ACCA - aglobalwall.com · Revision Mock Examination June 2017. Answer Guide Health Warning! How to pass Attempt the mock examination under exam conditions BEFORE looking at these

ACCA

Paper F7

Financial Reporting

Revision Mock Examination

June 2017

Answer Guide

Health Warning!

How to pass Attempt the mock examination under exam

conditions BEFORE looking at these suggested

answers. Then constructively compare your

answer, identifying the points you made well

and identifying those not so well made.

If you got the basics wrong then re-revise by

re-writing them out until you get them correct.

How to fail Simply read or audit the answers

congratulating yourself that you would have

answered the questions as per the suggested

answers.

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2 www.studyinteract ive.org

© Interactive World Wide Ltd, June 2017

All rights reserved. No part of this publication may be reproduced, stored in a retrieval

system, or transmitted, in any form or by any means, electronic, mechanical,

photocopying, recording or otherwise, without the prior written permission of Interactive

World Wide Ltd.

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www.studyinteract ive.org 3

Section A

1. B

Total services revenue = 125/100 × $200 × 2 years = $500

Total goods revenue = $3,000 − $500 = $2,500

Total revenue (y/e 31 March 2015) = $2,500 + (6/24 × $500) = $2,625

2. D

$000

Net proceeds -v-

Total payments

Par value 6,000 Interest

Less: Issue costs (120) 3.5% × 6,000

= 210 × 7 years = 1,470

+ Final redemption

payment including

premium 7,100

5,880 8,570

Therefore finance cost

= 2,690 (D)

3. D

Annual expense = $1,500 × 3 (#payments) / 4 years = $1,125

Expense (4 months) = 4/12 × $1,125 = $375

DR Op. lease rental expense (SPL) $375

CR Accruals (SFP) $375

4. A

The IP is recognised at fair value at 31 March 2015 of $550,000 on the statement

of financial position.

It has fallen in value from its previous fair value at 31 march 2014 of $600,000 and

so a loss of $50,000 is recognised though profit or loss.

5. C

Profit attributable to the ordinary equity holders = $500,000 – (10% × $100,000) =

$490,000

Weighted average number of shares = 400,000 + (400,000/2) = 600,000

Basic EPS = $490,000/600,000 = 81.7 cents per share

6. C

Temporary difference = $100,000

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@20% = $20,000 DT liability (carrying value > tax base)

Current year liability = $20,000

Prior year liability = $175,000

Reduction in liability = $155,000 = gain

7. A

Opening

$475,000

= $500,000 × 95%

$475,000 less

5,000 = $470,000

Effective Interest

@ 7%

$32,900

Cash Paid

($20,000)

= $500,000 × 4%

Closing

$482,900

8. A

This is the correct treatment for a bargain purchase.

9. D

TK no longer controls Theta so it is no longer considered a subsidiary and does not

need consolidating.

10. D

Apples, lemons and pears are examples of agricultural produce but not biological

assets.

11. C

A is treated using split accounting and would have both a liability and equity element.

B is the purchase of a debenture so would give rise to a financial asset and not a

financial liability.

D is treated as equity as the preference shares are irredeemable and there is

therefore no obligation to pay cash.

12. B

13. B

The effective rate of interest is used to calculate the borrowing costs capitalised.

Total annual interest in the first year of the loan is $100,000 ($2,000,000 ×5%)

Borrowing costs can only be capitalised from 1 October 2014, when borrowing costs

are being incurred, and so only $50,000 is capitalised, being six months from 1

October to 31 March.

14. C

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Depreciation (1 July 2014 to 31 March 2015 – 9 months) = $500,000 / 10 years ×

9/12 = $37,500

Carrying value = $500,000 - $37,500 = $462,500

Amortisation of government grant = $100,000 / 10 year × 9/12 = $7,500

Deferred income = $100,000 - $7,500 = $92,500

15. D

Both (iii) and (iv) increase the capital employed and reduce the ROCE.

(i) Will reduce the capital employed and therefore increase the ROCE.

(ii) The tax bill will have no impact on the profits before interest and tax and so does

not reduce the ROCE.

16. D

On conversion to ordinary shares there will be an increase in equity and hence a

decrease in gearing.

As the convertible instrument is no longer an issue there will be no interest costs

and so the interest decreases causing the interest cover to increase.

17. B

B is a prepayment and does not meet the definition of a financial instrument.

18. D

19. D

Both (i) and (ii) are non-adjusting events.

20. C

A change to the revaluation model for PPE would cause the capital employed to

increase. This would reduce the return on capital employed and reduce gearing.

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Section B

Answer 1: Primrose

Tutorial Help and Key Points

This is quite a searching question. Take great care when dealing with purchase

consideration — if only the cash payment has been recorded, the share exchange

therefore needs to be. Watch the share exchange and don’t get it the wrong way

round; divide the number of shares acquired by 4 and multiply the result by 2 —

these shares are in the parent. The deferred consideration needs to be discounted

at 7% and by the year end this discount must be unwound.

When dealing with the PUP don’t forget that it is the unsold items that must be

considered so take one third. Also note the 25 cents par value of the ordinary

share capital.

Watch the seasonal-variation nature of the Associate’s profits; also the figure

given for Impairment of Associate must be taken in full, not group share, as the

entire Associate value is being written down, not just it’s goodwill.

For Marking Guide see main answer

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(Marks)

(a) Valuation of Associate Agapanthus: $m

Investment at cost 20 ½

Group share of Associate’s post-acqn Retained Earnings

(30% × 6m)

1.8 1

Less: Impairment (2.8) ½

Investment in Associate A (in CSFP) 19 2

(b) Goodwill in subsidiary Sunflower

Investment in Sunflower: $m

Cash consideration 180 ½

Primrose shares (900/4 × 2 × 0.90c) 405 1

Note: $112.5m share capital / $292.5m share premium

Deferred cash (900m × 17c = $153m × 1/1.07 ie 0.9346) 143 1½

728

Therefore calculation of Goodwill in Sunflower: $m

Investment at cost

CI 728

Fair value of NCI at acq’n given 177 ½

Less: Fair value of net assets at acq’n (566) 2

Goodwill at aquisition 339

Less: goodwill impairment (40) ½

Goodwill at net book value (in CSFP) 299 6

(c) Non-controlling interest

$m

Fair value of NCI at acq’n given 177 ½

NCI % post acquisition reserves of sub (25% × 20m) 5 1

NCI % goodwill impairment (25% × 40) (10) ½

NCI (CSFP) 172 2

(d) Consolidated reserves

$m

Primrose 450 ½

Group share of S’s post acquisition (75% × $20m) 15 1

A’s post acquisition (30% × $6m) 1.8 1

Less: Group share of goodwill impairment in Sunflower (30) ½

Impairment of Associate (2.8) ½

Less: Discount unwound ($143m × 7%) (10) 1½

Total to CSFP 424 5

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Working – Group structure

30% Associate Agapanthus acquired mid-year

Working – Consolidation Adjustments and Net assets

Per Q

Fair value adjustment for PP+E in S:

$m

Fair value adjustment at acquisition 90

Post-acquisition depreciation (90/18 yrs × 1 yr) (5)

Fair value adjustment at consolidated SFP date 85

Unrealised profit adjustment:

1/3 of inventory left within the group at the year-end:

$m

Transfer price ($12m × 1/3) 4

Cost ($4m × 75%) (3)

Unrealised profit 1

Dr Retained earnings - Sunflower (subsidiary is the seller) $1m

Cr Group inventory $1m

Elimination of current account (intra-group trading):

Cash in transit:

Dr Bank (C I T) $7m

Cr Receivables (Sunflower) $7m

Elimination of current accounts:

Dr Payables (Primrose) $4m

Cr Receivables (Sunflower) $4m

Primrose

Sunflower Subsidiary

75%

900m ______

1,200m

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Net assets list

Sunflower

At acq'n At CSFP

$m $m

Share capital 300 300

Retained earnings 180 210

PP+E (FV adj) 90 90

Post acq’n depreciation - (5)

Software (FV adj: given in (ii))

PUP adj

(4)

-

566

(8)

(1)

586

For G/W

Difference of $20m to NCI

and Consolidated Reserves

Associate Agapanthus’ $18 million profits are seasonal and spread as $12m pre-

acquisition, $6 million post-acquisition. It is the Group share (30%) of the latter portion

($6 million) that must be used in valuing the Associate and increasing Consolidated

Reserves.

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Primrose Group’s statement of financial position as at 30 November 2014

(shown here for tutorial purposes only)

$000

Non-current assets

Property, plant and equipment (960 + 510 + 90 – 5 [W]) 1,555

Intangible: Software (W) 40

Goodwill (W) 299

Investment in Associate (W) 19

1,913

Current assets

Inventory (94 + 30 – 1 [W]) 123

Receivables (126 + 66 – 7 – 4 [W]) 181

Bank (nil + 6 +7 [W]) 13

317

Total assets 2,230

Equity and liabilities

Equity

Ordinary share capital (450 + 112.5 [W]) 562.5

Share Premium (W) 292.5

Retained earnings (W) 424

1,279

Non-controlling interest (W) 172

1,451

Non-current liabilities

10% loan notes (180 + 30) 210

Current liabilities

Payables (195 + 86 – 4 [W]) 277

Income taxes payable (68 + 34) 102

Deferred consideration (discount unwound) 153

Overdraft 37

569

Total equity and liabilities 2,230

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Answer 2: Jennie Mae


This is a long question as is often the case in the exam. To speed up the process

you must memorise the format for the statement of cash flow.

There are three sections:

Depreciation must be added back to profit before tax as must loss and

disposal, and interest expense – remember you are doing the opposite of what

was done in the income statement, ie, negating the effect of the earlier

treatment in the P & L.

Next comes the working capital movements, always imagining that the

movement is in cash and each movement being considered in isolation.

Finally comes interest paid and tax paid.

Keep time to write the report in part (b) and as this is usually badly done by

students, a reasonable attempt will earn you several marks.

Marking Guide

Marks

(a)

Statement of cash flows

Profit before tax ½

Depreciation 1

Loss on disposal ½

Interest expense ½

Working capital movements 1½

Interest paid ½

Tax paid 1

Purchase of PP+E 1

Issue of share capital ½

Receipt of loan ½

Dividends paid ½

8

(b)

Up to 3 marks for ratio calculations 3

1 mark for each relevant point

up to a max of 4

Total for question 7

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(a) Jennie Mae’s statement of cash flows for the year ended 31 March 2015

$000 $000

Cash flows from operating activities

Profit before tax 1,750

Adjustments for:

Depreciation (W1) 9,375

Loss on disposal (W1) 3,125

Interest expense 750

15,000

Increase in receivables (250 − 125) (125)

Increase in inventory (7,250 − 3,750) (3,500)

Increase in payables (7,750 − 5,375) 2,375

Cash generated from operations 13,750

Interest pd (750)

Taxation paid (1,125 + 625 − 550) (1,200)

Net cash from operating activities 11,800

Cash flows from investing activities

Purchase of PP+E (W1) (26,250)

Net cash used in investing activities (26,250)

Cash flows from financing activities

Issued share capital (12,500 + 2,500 − 7,500) 7,500

Receipt of loan (7,500 − 2,500) 5,000

Dividends paid (4,750 + 1,125 − 4,375) (1,500)

Net cash from financing activities 11,000

Net decrease in cash and cash equivalents (3,450)

Opening cash and cash equivalents 1,125

Closing cash and cash equivalents (2,325)

Workings

W1 – PPE

Cost

Opening 23,750

Less: Disposals (7,500)

Opening has become 16,250

But Closing is 42,500

Therefore additions = balancing figure 26,250

Accum Dep’n

Opening 7,500

Less: Disposals (7,500 – 3,125) (4,375)

Opening has become 3,125

But Closing is 12,500

Therefore Dep’n charged for year = 9,375

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Disposals

Cost 7,500

Less: Accumulated Dep’n (4,375)

NBV 3,125

(Scrapped, therefore Loss on Disposal = NBV of 3,125)

Or alternative presentation:

PPE Cost

B/f 23,750 Disposals 7,500

Additions (Bal fig) 26,250 C/f 42,500

50,000 50,000

PPE Accumulated dep'n

Disposals (7,500 − 3,125) 4,375 B/f 7,500

C/f 12,500 Depreciation expense (Bal fig) 9,375

16,875 16,875

PPE Disposals

Cost 7,500 Accumulated depreciation 4,375

Loss on disposal (Bal fig) 3,125

7,500 7,500

(b) Introduction

This report investigates the overall financial performance and financial position of

Jennie Mae with particular reference to the increase of sales revenue and reduced

profitability from the financial period ended March 2014 to March 2015. An analysis of

ratios calculated has been given as an appendix at the end of this report.

Financial performance

During the year to 31 March 2015 sales revenue had increased by 17%, this shows

that the hiring of the supermodel to endorse the women’s clothing line has had a

positive impact. However, the gross profit margin has decreased from 19.9% in 2014

to 16.3% in 2015. This suggests that although volumes of clothing sold have possibly

increased, the margins achieved on those sales may have decreased, suggesting

discounts have been given to shift inventory on less popular lines of clothing.

Even with discounted prices, the inventory holding period has increased from 35 days

to 55 days which is rather worrying because with such a fashionable and seasonal

business like clothing, holding on to inventory for too long runs the risk of it becoming

obsolete. It must be noted that because of this large increase in the number of days

inventory being held, it is expected that large inventory write downs may be necessary

in order to sell the inventory in the future.

The operating profit margin has decreased from 10.2% in 2014 to 4.3% in 2015 this

is because of the operating expenses growing at a much faster rate (44.7%) than the

sales revenue. This is extremely worrying as normally expenses are expected to

decrease as a percentage of sales as economies of scale come into effect. This suggests

poor cost control or some one-off expenses associated with the acquisition and

refurbishment of stores.

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The net profit margin has also fallen from 7.1% to 1.9% this is mainly due to the

increase in finance costs, which were attributable to an increase in a long-term loan

taken out in 2015 along with the increase in operating expenses, mentioned above.

The high level of investment and poor profitability has led to a decline in the return on

capital employed from 33.9% to 9.3%. Hopefully this should improve in future years

as the return on investment will improve with higher profits.

Conclusion

Although the 2015 results are disappointing in terms of performance in relation to the

high level of investment there are a lot of positive things to take into the future for the

company such as the high level of cash generated from operations which if continued

into future periods could greatly reduce the finance costs and debts. Hopefully next

year should see the profits improve with this year’s capital expenditure, without the

disruption caused by development.

Appendix

(additional ratios provided for tutorial purposes)

2015 2014

Gross profit margin 16.3% 19.9%

Net profit margin 1.9% 7.1%

Return on capital employed 9.3% 33.9%

Gearing 28% 17%

Interest cover 3.3 times 25 times

Current ratio 0:71:1 0:77:1

Inventory days 55 days 35 days

Payables payment period 59 days

Increase in sales revenue 17%

Operating profit margin 4.3% 10.2%

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Answer 3: Kasabian


Learn the formats for published accounts and for the SOCIE.

Cost of sales must include carriage inwards, depreciation, etc.

The buildings revaluation is a loss and as it was at the year end, depreciation for

the year must first be charged. The change in investment property value must be

transferred to the P & L proper, and not shown in the other comprehensive income

section.

Take care with calculating interest charge to P & L as this must be the effective

rate of 6%.

Master the C.U.D. mnemonic for tax and remember that an over-provision is always

a credit, and under-provision a debit.

Tax is always examined and the need to be able to write about deferred tax has

been emphasised in recent articles in the student magazines.

Marking Guide

Marks

(a)

SPLOCI:

Revenue ½

Cost of sales 3

Investment income 1

Administration costs 1

Distribution costs 1

Finance costs 1

Taxation 1½

9

(b)

Statement of financial position:

Property, plant and equipment 3

Investment property 1

Inventory ½

Receivables ½

Ordinary share capital 1

Share premium 1

Retained earnings 1

Revaluation reserve 1

Debentures 1

Deferred tax 1

Trade payables ½

Current tax ½

Bank 1

13

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(c)

Statement in changes in equity:

Correct layout and presentation 1

Share issue (split between OSC and SP) 1

Revaluation loss ½

Profit for the year ½

3

(d)

One mark for each reasonable point to a maximum of five 5

Total for question 30

(a) Kasabian’s statement of profit or loss and other comprehensive income for

the year ended 31 March 2015

$000

Revenue 315,700

Cost of sales (W1) (184,800)

Gross Profit 130,900

Investment income (3,850 + 3,710 [W3]) 7,560

Distribution costs (W1) (21,000)

Administration expenses (W1) (23,625)

Operating profit 93,835

Finance costs (W4) (4,155)

Profit before tax 89,680

Taxation (W5) (32,000)

Profit for the year 57,680

(b) Kasabian’s statement of financial position as at 31 March 2015

$000 $000

Non-current assets

Property, plant and equipment (W2) 356,300

Investment property (46,375 + 3,710 [W3]) 50,085

406,385

Current assets

Inventory 66,325

Receivables 61,425

127,750

Total assets 534,135


Equity

Share capital (105,000 + 35,000 [W6]) 140,000

Share premium (W6) 7,000

Revaluation reserve (24,500 - 7,000 [W2]) 17,500

Retained earnings (44,625 + 57,680) 102,305

266,805

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2% Loan notes (W4) 141,255

Deferred tax (W5) 20,000

161,255

Current liabilities

Payables 60,725

Current tax (W5) 32,300

Bank (11,550 + 1,500) 13,050

106,075

Total equity and liabilities 534,135

(c) Kasabian’s statement of changes in equity for the year ended 31 March 2015

Share

Capital

Share

Premium

Revaluation

Reserve

Retained

Earnings

Total

$000 $000 $000 $000 $000

At 1 April 2014 105,000 - 24,500 44,625 174,125

Revaluation loss (W2) (7,000) (7,000)

Share issue (W6) 35,000 7,000 42,000

Profit for the year 57,680 57,680

At 31 March 2015 140,000 7,000 17,500 102,305 266,805

Workings

Costs

Cost of

Sales

Distribution

Costs

Admin

Expenses

$000 $000 $000

Per trial balance 19,250 21,875

Opening inventory 33,100

Carriage inwards 125

Purchases 189,200

Closing inventory (66,325)

Depreciation (W2)

Buildings 3,500 1,750 1,750

Plant 25,200

Total to income statement 184,800 21,000 23,625

PP+E

Land Buildings Plant Total

$000 $000 $000 $000

Valuation/Cost 52,500 175,000 224,000 451,500

Accumulated depreciation (56,000) (56,000)

Carrying value at 1 April 2014 52,500 175,000 168,000 395,500

Depreciation for the year

Buildings (175,000/25 years) (7,000) (7,000)

Plant (168,000 × 15%)

(25,200) (25,200)

CV prior to year-end revaluation 52,500 168,000 142,800 363,300

Revaluation loss (Bal. figure) (7,000) (7,000)

Carrying value at 31 March 2015 52,500 161,000 142,800 356,300

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Investment property

$000

Fair value per trial balance 46,375

Gain on change in fair value (46,375 x 8%) 3,710

Fair value at 31 March 2015 50,085

Note: The gain on the increase in FV on investment property is recognised as

income in the P & L per IAS 40.

Finance costs

The loan note is a financial liability, which is held to maturity, the standard

states that issue costs must be deducted from the proceeds when initially

measuring the liability.

$000

Opening liability (net proceeds) at 1 October 2014

(140,000 − 1,500) 138,500

Interest (6% × 6/12) 4,155 To I/S

Interest paid (1,400)

Closing liability at 31 March 2015 141,255

Taxation

$000

Taxation in the P & L:

Current Tax 32,300

Over provision (700)

DT movement* 400

32,000

$000

Deferred tax in the statement of financial position:

At 1 April 2014 19,600

Movement (Bal fig)* 400

At 31 March 2015 (80,000 × 25%) 20,000

Share issue

No. of shares eligible for rights issue ($105,000/50c = 210,000/3 x 1) 70,000

Dr Suspense $42,000

Cr Share capital (70,000 × 50c) $35,000

Cr Share premium (70,000 × 10c) $7,000

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(d) IAS 12 defines deferred tax liability as being the amount of income tax payable in

future periods in respect of taxable temporary differences. Temporary differences are

defined as being differences between the carrying amount of an asset (or liability) and

its tax base, which the asset is valued at for tax purposes by the tax authority. Put

simply, the temporary differences arise when income or expenditure is recognised in

the financial statements in one year, but is charged or allowed for tax in another.

A classic example of a situation where deferred tax is required to be provided for is

non-current assets. Deferred tax arises due to differences between depreciation

charged to the financial statements and the tax depreciation (capital allowances)

charged to taxable profits by the tax authorities.

The deferred tax usually arises as a result of the company receiving capital allowances

that depreciate the asset at a faster rate for tax purposes than the rate of depreciation

charged in the financial statements. This results in accounting profits being higher in

the early years of the assets life than taxable profits, thus resulting in the actual tax

charge being too low in comparison with the accounting profits. However, in the long-

term these differences will even out over the life of the asset, so at some point in the

future the accounting profits will be lower than the taxable profits therefore resulting

in a higher tax charge in the future.

For example, if the profits of a company remain constant over several years, the

resulting higher tax charge in future periods will distort the view of the financial

statements, as it would appear that performance is deteriorating, when it is not

necessarily the case. The company will not want to mislead investors who value

companies based on post-tax profits, therefore a deferred tax adjustment is necessary.

By recognising this future tax charge as a temporary difference, the tax expense will

be comparable with the reported performance of the company.

The effect of the deferred tax in the statement of profit or loss and other comprehensive

income would be the movement in the deferred tax liability being added or deducted

to the current tax charge for the year. In the statement of financial position a deferred

tax liability is created by calculating the difference between the carrying value of the

asset and its tax base, this would give the temporary difference which would then have

the appropriate tax rate applied to it.

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ACCA

Paper F7

Financial Reporting

Revision Mock

Examination June 2017

Question Paper

Time Allowed 15 minutes Reading and planning

3 hours Writing

All questions are compulsory and MUST be attempted

This paper is divided into two sections:

Section A: ALL TWENTY questions are compulsory and MUST be

attempted.

Section B: ALL THREE questions are compulsory and MUST be

attempted.

Do NOT open this paper until instructed by the supervisor.

During reading and planning time only the question paper

may be annotated. You must NOT write in your answer

booklet until instructed by the supervisor.

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2 www.studyinteract ive .org


All rights reserved. No part of this publication may be reproduced, stored in a

retrieval system, or transmitted, in any form or by any means, electronic,

mechanical, photocopying, recording or otherwise, without the prior written

permission of Interactive World Wide Ltd.

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This is a blank page.

Section A starts on page 4.

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Section A – ALL TWENTY questions are compulsory and MUST be

attempted.

Each question is worth 2 marks.

1. AB sells computer equipment with a two-year service agreement for a total of $3,000

on 1 October 2014. The cost of providing the service guarantee is $200 per annum and

AB usually charges a 25% mark-up on cost when selling the service separately.

How much revenue should be recognised in the financial statements for the

year ended 31 March 2015?

A. $2,500

B. $2,625

C. $2,750

D. $3,000

2. On 1 January 2015, an entity issued a debt instrument with a coupon rate of 3.5% at

a par value of $6,000,000. The directly attributable costs of issue were $120,000. The

debt instrument is repayable of 31 December 2021 at a premium of $1,100,000.

What is the total amount of the finance cost associated with the debt

instrument?

A. $1,470,000

B. $1,590,000

C. $2,570,000

D. $2,690,000

3. GD enters into a four-year operating lease of a motor vehicle at $1,500 per annum

payable at the end of the year. The lease commenced on 1 December 2014 when GD

negotiated a one-year rent-free period.

Calculate the amounts to be recognised in the financial statements for the

year ended 31 March 2015.

Statement of financial

position – accrual

Statement of profit

or loss – expense

A. $1,125 $1,125

B. $nil $nil

C. $500 $500

D. $375 $375

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4. TD owns an investment property that cost $500,000 on 1 April 2013. Its fair value on

31 March 2014 was $600,000 and $550,000 on 31 March 2015. TD uses the fair value

model to account for its investment properties.

What amounts would appear in the financial statement for the year ended 31

March 2015?

Statement of financial

position – investment

property

Statement of profit

or loss

A. $550,000 $50,000 loss

B. $600,000 $100,000 gain

C. $550,000 $50,000 gain

D. $600,000 $100,000 loss

5. AM has a profit for the year ended 31 March 2015 of $500,000 and there were

$100,000 10% irredeemable preference shares in issue during the year. AM had

400,000 equity shares in issue at 1 April 2014 and made a 1-for-2 bonus issue on 1

May 2014.

Calculate the basic EPS figure for the year ended 31 March 2015.

A. 83.3 cents per share

B. 62.5 cents per share

C. 81.7 cents per share

D. 61.3 cents per share

6. JR has a deferred tax liability at 31 March 2014 of $175,000. At 31 March 2015 the

carrying value of its assets and liabilities was $800,000 and their tax base was

$700,000. The tax rate enacted at the year-end was 20%.

What is the effect on profit or loss for the year ended 31 March 2015?

A. $275,000 gain

B. $195,000 gain

C. $155,000 gain

D. $75,000 gain

7. TD acquired a 4% $500,000 debenture at a discount of 5% on 1 April 2014, incurring

directly attributable transaction costs of $5,000. The effective rate of interest on the

debenture is 7%.

What amounts should be shown in the statement of financial position of TD

at 31 March 2015?

A. $482,900

B. $489,250

C. $513,250

D. $515,000

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8. JD, a parent company, acquired AS, an unincorporated entity, for $1.8 million. A fair

value exercise was performed on AS's assets and liabilities and showed at the date of

purchase:

$'000

Property, plant and equipment 3,000

Identifiable intangible asset 500

Inventory 300

Trade receivables less payables 200

4,000

How should the purchase of AS be reflected in JD's consolidated statement of

financial position?

A. Record the net assets at their values shown above and credit profit or loss with

$2.2 million

B. Record the net assets at their values shown above and credit JD's consolidated

goodwill with $2.2 million

C. Write off the intangible asset ($500,000), record the remaining net assets at their

values shown above and credit profit or loss with $1,700,000

D. Record the purchase as a financial asset investment at $1.8 million

9. TK owns 100% of the share capital of the following companies. The directors are unsure

whether the investments should be consolidated.

In which of the following circumstances would the investment not be

consolidated?

A. TK has decided to sell its investment in Omega as it is loss-making; the directors

believe its exclusion from consolidation would assist users in predicting the group's

future profits

B. Kappa is a bank and its activity is so different from the engineering activities of the

rest of the group that it would be meaningless to consolidate it

C. Rho is located in a country where local accounting standards are compulsory and

these are not compatible with IFRS used by the rest of the group

D. Theta is located in a country where a military coup has taken place and TK has lost

control of the investment for the foreseeable future

10. Which of the following are NOT examples of biological assets as per IAS 41

Agriculture?

A. Trees in a plantation forest

B. Plants for harvest

C. Sheep, pigs and cattle

D. Apples, lemons and pears

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11. Which of the following would be classified (only) as a liability in the financial

statements?

A. A 5% debenture that is convertible at the option of the holder into ordinary equity

shares at any point during the next five years

B. The purchase of a redeemable bond that is redeemable in three years' time

C. The issue of 6% loan notes that are redeemable in four years' time

D. The issue of irredeemable preference shares

12. The role of which supervisory accountancy body is described as "to develop,

in the public interest, a single set of high quality, understandable, enforceable

and globally accepted financial reporting standards based upon clearly

articulated principles"?

A. IFRS Advisory Council

B. IFRS Foundation

C. IFRS Interpretations Committee

D. IASB

13. NY began the construction of a children's centre on 1 July 2014. To finance the

construction of the centre NY issued loan notes of 4% $2,000,000 on 1 October 2014

redeemable in five years' time at a premium. The effective rate of interest on the loan

notes is 5%.

In accordance with IAS 23 Borrowing Costs how much interest should be

capitalised for the year ended 31 March 2015?

A. $40,000

B. $50,000

C. $60,000

D. $75,000

14. FC purchases an item of plant for $500,000 on 1 July 2014 and receives a grant of

$100,000 against the purchase. The asset has a useful life of 10 years with no residual

value. FC uses the deferred income method to account for government grants.

What amounts will appear in the statement of financial position for the year

ended 31 March 2015?

A. Plant $450,000 and total deferred income of $90,000

B. Plant $360,000 and deferred income of £92,500

C. Plant $462,500 and total deferred income of $92,500

D. Plant $346,667 and deferred income of $90,000 prepa

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15. The Return on Capital Employed (ROCE) for VJ has reduced from 21.6% to 15.4% in

the year to 31 March 2015.

Which of the following independent options would be a valid reason for this

reduction?

Repayment of a long term loan

A large tax bill accrued

Major investment in intangible assets just before the reporting date

An upwards revaluation of land in the year

A. (i) and (ii)

B. (i) and (iii)

C. (ii) and (iv)

D. (iii) and (iv)

16. OP has 3% convertible bonds in issue and they are due to be converted or redeemed

within the next three months. Assume that no further debt is issued by OP in the year.

Which of the following statements are TRUE if all the holders choose to

convert to ordinary shares in OP?

Interest costs will decrease and gearing will increase following conversion

Gearing will decrease and earnings per share will increase if all of these instruments

are converted

Interest cover will increase and gearing will decrease following conversion

The P/E ratio will increase or decrease depending on how the market reacts to the

conversion to ordinary shares

A. (i), (ii) and (iv)

B. (ii), (iii) and (iv)

C. (i) and (ii)

D. (iii) and (iv)

17. Which of the following is not a financial instrument as per IAS 39?

A. The recording of an electricity expense at year-end for which the invoice has not

yet been received

B. The correcting of a 15-month expense that has been recorded in the general ledger

to ensure that only 12 months of expense are recorded in the period

C. The purchase of shares in an unlisted business

D. The issue of irredeemable preference shares

18. Which of the following would NOT give rise to a provision in the financial

statements?

A. Contamination of land by an oil company where there is no current law to clean up

but at year-end it is virtually certain that the law will be enacted shortly

B. A lease agreement that has been cancelled two years early but for which the lease

payments still need to be made for the remaining two years

C. Warranty given for goods or services

D. A restructuring plan which a detailed formal plan but has not yet been implemented

or communicated to employees

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19. Which of the following items is NOT an example of a non-adjusting event?

The change in value of an investment after the reporting date

The sale of property before the year-end that is conditional on planning permission

being granted. Planning permission is granted after the reporting date and the sale

is completed

Discovery of a miscalculation of the depreciation charge for the financial year after

the reporting date

The sale of the inventory after the reporting date that gives evidence that the net

realisable value is below its cost

A. (i) and (ii)

B. (ii) and (iv)

C. (i) and (iii)

D. (iii) and (iv)

20. LP has changed its accounting policy for its property during the year from one of historic

cost to the revaluation model.

Which of the following would NOT be directly affected by the change in policy?

Return on capital employed

Gearing

Quick ratio

Receivable days

A. (ii) and (iii)

B. (i) and (ii)

C. (iii) and (iv)

D. None of the above

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Section B – ALL THREE questions are compulsory and MUST be

attempted

1. Primrose, a public listed company, acquired 900 million ordinary shares in Sunflower

on 1 December 2013. The purchase consideration is made up as follows:

An immediate cash payment of $180 million

A share exchange of two shares in Primrose for four shares in Sunflower

A deferred cash payment of 17 cents per share acquired, payable on 1 December 2014

Primrose has only recorded the cash payment. The value of each share in Primrose

and Sunflower at the date of acquisition was 90 cents and 59 cents respectively. The

Primrose cost of capital is 7% per annum (present value factor 0.9346).

The statements of the financial position of the two companies at 30 November 2014

are shown below:

Primrose Sunflower

$m $m $m $m

Non-current assets

Property, plant and equipment 960 510

Intangible: Software Nil 48

Investments

In Sunflower 180 Nil

In Agapanthus 20 Nil

Current assets

Inventory 94 30

Trade receivables 126 66

Bank Nil 6

220 102

Total assets 1,380 660


Equity

Equity shares of 25 cents each 450 300

Retained earnings

1 Dec 2013 315 180

year ended 30 Nov 2014 135 30

450 210

900 510


10% loan notes 180 30

Current liabilities

Trade payables 195 86

Income taxes payable 68 34

Operating overdraft 37 Nil

300 120

Total equity and liabilities 1,380 660

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The following information is relevant:

On the 1 December 2013 the fair value of Sunflower’s property, plant and

equipment exceeded their carrying value by $90 million. The property, plant and

equipment had a remaining useful life of 18 years at this date.

The software of Sunflower represents the amortised development cost of an

integrated electronic reporting package. It requires a reduction of $4 million at

acquisition and a reduction of $8 million at consolidation date (ie $48 million less

$8 million, or $40 million at consolidation).

Sunflower sold goods to Primrose for $12 million in the post-acquisition period.

One third of these goods remain in inventory at 30 November 2014. Sunflower

applies a 25% gross profit margin on all sales.

Sunflower’s trade receivables account balance includes $11m due from Primrose

at the year-end. However this does not agree with the current account balance

included within Primrose’s trade payables account due to cash-in-transit of $7

million paid by Primrose.

Primrose bought 10 million shares in Agapanthus on 1 June 2014; this represents

a holding of 30% of Agapanthus’ equity. Agapanthus’ profit is subject to seasonal

variation. Its profit for the year ended 30 November 2014 is $18 million; $12

million was made from 1 December 2013 to 31 May 2014. Primrose uses equity

accounting in its consolidated financial statements for its investment in

Agapanthus.

Goodwill is reviewed for impairment annually. At 30 November 2014 there had

been an impairment loss of $40 million in the value of consolidated goodwill since

acquisition. Due to the difficult economic conditions as evidenced by falling

profits, the value of the investment in Agapanthus was impaired by $2.8 million.

It is group policy to value the non-controlling interest at acquisition at full (or

fair) value (59¢ × 300 shares ie $177 million).

Required:

Prepare figures to be shown in the consolidated statement of financial

position of Primrose as at 30 November 2014 for

(a) Valuation of Associate (2 marks)

(b) Goodwill in Subsidiary (6 marks)

(c) Non-controlling Interest (2 marks)

(d) Consolidated Reserves (5 marks)

Provide full workings, but the preparation of the consolidated statement of

financial position is not required.

(15 marks)

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2. Jennie Mae, a public company, is a national clothing retailer that sells luxury designer

clothing. The company has recently expanded its operations and commissioned a

famous supermodel to endorse its women’s clothing line. This has led to increased

sales, however; overall profits of the company are down.

The managing director of the company has expressed her extreme disappointment

with the current year’s results and would like an explanation as to why these increased

sales has not led to increased profitability.

Details of Jennie Mae’s financial statements for the two years to 31 March 2015 are

shown below.

Statements of profit or loss and other comprehensive income for the year

ended:

31 March

2015

31 March

2014

$000 $000

Revenue 57,500 49,000

Cost of sales (48,125) (39,250)

Gross profit 9,375 9,750

Operating expenses (6,875) (4,750)

Operating profit 2,500 5,000

Interest expense (750) (200)

Profit before tax 1,750 4,800

Taxation expense (625) (1,300)

Profit for the year 1,125 3,500

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Statements of financial position as at:

31 March 2015 31 March 2014

$000 $000 $000 $000

Non-current assets

Property, plant and equipment

(note i)

30,000

16,250

Current assets

Inventory 7,250 3,750

Trade receivables 250 125

Bank Nil 1,125

7,500 5,000

Total assets 37,500 21,250


Equity

Ordinary share capital ($1) 12,500 7,500

Share premium 2,500 Nil

Retained Earnings 4,375 4,750

19,375 12,250


Long-term loans 7,500 2,500

Current liabilities

Bank overdraft 2,325 Nil

Trade payables 7,750 5,375

Income tax payable 550 1,125

10,625 6,500

Total equity and liabilities 37,500 21,250

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Property, plant and equipment can be analysed as follows:

2015 2014

$000 $000

Cost 42,500 23,750

Accumulated depreciation (12,500) (7,500)

Carrying amount 30,000 16,250

The increase in property, plant and equipment was due to the acquisition of six

new stores in the London area and the refurbishment of existing stores in the

regions. Because of the refurbishment, some fixtures and fittings were scrapped

which has a book value of $3.125 million and had originally cost $7.5 million.

These fixtures had no scrap value.

Dividends paid by the company to ordinary shareholders were $1.5 million in

both 2014 and 2015. The directors have signalled their intention to maintain the

annual dividend at $1.5 million for the foreseeable future.

The following ratios have been calculated for 2014:

Gross profit margin 19.9%

Operating profit margin 10.2%

Net profit margin 7.1%

Return on capital employed 33.9%

Gearing 17.0%

Interest cover 25 times

Required:

(a) Prepare the statement of cash flow for Jennie Mae for the year ended 31

March 2015 using the indirect method. (8 marks)

(b) Provide a brief explanation of financial performance to the managing

director. (7 marks)

(15 marks)

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3. The following trial balance relates to Kasabian, a listed company, at 31 March 2015.

$000 $000

Ordinary shares 50 cents each 105,000

Retained earnings at 1 April 2014 44,625

Revaluation reserve (from land and buildings) 24,500

2% Loan Note 2018 140,000

Revenue 315,700

Investment properties at valuation 1 April 2014 46,375

Land and buildings at valuation 1 April 2014 227,500

Plant at cost 1 April 2014 224,000

Plant - accumulated depreciation 1 April 2014 56,000

Distribution costs 19,250

Administration expenses 21,875

Inventory at 1 April 2014 33,100

Debenture interest paid 1,400

Income tax 700

Carriage inwards 125

Investment income 3,850

Purchases 189,200

Trade receivables 61,425

Trade payables 60,725

Bank 11,550

Deferred tax 19,600

Suspense account

42,000

824,250 824,250


The 2% Loan Note was issued on 1 October 2014 under terms that provide for a

large premium upon redemption in 2018. The finance department has calculated

that the effective interest rate of this type of debt instrument is 6% per annum.

Kasabian also paid in cash issue costs of $1.5 million; these have yet to be

accounted for. Kasabian intends to hold these loan notes to maturity.

Kasabian has a policy of revaluing its land and buildings to their fair value at each

year-end. The valuation of land and buildings includes a land element of $52.5

million. On 31 March 2015 a professional valuer valued the buildings at $161

million with no change to the value of land. The estimated remaining life of

buildings at 1 April 2014 was 25 years. Depreciation is charged 50% to cost of

sales, 25% to distribution costs and 25% to administration expenses.

Later, the valuers informed Kasabian that investment property of the type

Kasabian owned had increased in value by 8% in the year to 31 March 2015.

Plant is depreciated at a rate of 15% per annum using the reducing balance

method and charged to cost of sales.

The directors of Kasabian have estimated the income tax liability for the year

ended 31 March 2015 at $32.3 million. The balance of the income tax account

in the trial balance represents under/over provision of the previous year’s

estimate. At 31 March 2015 there were $80 million of taxable temporary

differences due to capital allowances exceeding depreciation. The applicable tax

rate is 25%.

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The suspense account in the trial balance represents the credit entry for the

proceeds of a one for three rights issue of ordinary shares made on 1 February

2015. The issue was for 60 cents per share. The issue was fully subscribed.

Inventory on 31 March 2015 was $66,325,000.

Required:

Prepare for Kasabian

(a) a statement of profit or loss and other comprehensive income statement

for the year ended 31 March 2015; (9 marks)

(b) a statement of financial position as at that date; and (13 marks)

(c) a statement of changes in equity for the year ended 31 March 2015.

(3 marks)

(d) You have been asked to also prepare a memo for one of the non-executive

directors of your company. The director is not familiar with accounting, and would

like to know more. He is particularly confused by deferred taxation in the financial

statements, because he has never heard of any such tax.

Required:

Prepare a brief memo for the non-executive director, and in it explain

the purpose of deferred taxation, and the main accounting requirements

of IAS 12 Income Taxes for deferred tax. (5 marks)

(30 marks)

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ACCA Paper F8

Audit and Assurance Revision Mock Examination

June 2017

Answer Guide

Health Warning!

How to pass Attempt the examination under exam conditions

BEFORE looking at these suggested answers.

Then constructively compare your answer,

identifying the points you made well and

identifying those not so well made.

How to fail Simply read or audit the answers congratulating

yourself that you would have answered the

questions as per the suggested answers.

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World Wide Ltd.

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Section A

Question Answer See Note

1. B 1

2. B 2

3. C 3

4. D 4

5. A 5

6. A 6

7. D 7

8. B 8

9. D 9

10. A 10

11. B 11

12. C 12

Notes:

1. Answer A is a substantive test and C is a test of control.

2. Option 3 implies the company is not a going concern as it is about to lose most

of its revenues. Option 2 is a going concern threat, but there is enough cash to

pay off the loans if this is demanded by the lender, so the company could survive.

Item 4 represents an understated provision equating to 6% PBT which is

material, whereas item 1 is a 4% PBT error and not material.

3. Contingent fees are banned because there are no safeguards that could reduce

the threat enough. In A and D, safeguards could reduce the threats (e.g. careful

staff selection, use of staff from another office of the firm, hot reviews). Option

B is not a major threat because a marketing manager plays no role in preparing

accounting records or the financial statements.

4. The other 2 options are audit software.

5. For P or L items, the assertions are completeness, occurrence, cut-off,

classification and accurate values. Existence and rights & obligations relate to the

statement of financial position.

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6. Tests of control involve checking the system. Substantive tests check the info in

the FS is correct. The tests are therefore the wrong way round.

7. Option 2 is describing stratification not extrapolation. Haphazard sampling is

dangerous as without a clear method of selection it would be easy for audit staff

to introduce bias into the selection.

8. Auditors should TRY to detect all material fraud – by assessing the risk of ALL

material misstatement (whether fraud or error) and designing responses to these

risks. Auditors cannot be required to find all fraud, because most of it is

committed by directors and senior management, who are powerful enough to be

able to hide their activities.

9. It is the Opinion that is unmodified – the Report IS modified (the addition of the

extra paragraph is the modification). Option 1 is describing an Other Matter

paragraph.

10. To reduce detection risk, either sampling risk must be reduced (e.g. a bigger

sample size, which is unlikely if materiality is increasing) or non-sampling risk

must be reduced (which would be achieved with better quality audit staff). More

substantive testing would achieve the first of these. Risk of material

misstatement is the combination of inherent and control risk. If this is now

considered higher than first thought, the only solution is reducing detection risk.

Auditors cannot reduce control risk – this is a risk for the client to address, not

the auditor.

11. This is an adjusting event per IAS 10, because it provided evidence (before the

directors signed the FS) that a customer balance due at the year end, would not

be recoverable. Hence, the balance should be written off. The auditor would need

to check it was corrected, but must then extend audit work and issue a new

report on/after the date that the corrected FS are signed by the directors. This is

largely because the IAS 10 period for EARP will now run up to the new set of FS

being signed, meaning more adjustable or disclosable events might have taken

place.

12. The law requires A to be reported, and public interest suggests B should also be

reported. Item C is company strategy and as such would be likely to cause them

commercial damage if reported.

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Section B

MARKING GUIDE

In all questions, there is up to 1 mark for each valid point if it is in a sentence and

clearly stated/explained.

Any point made which is correct but unclear or lacking sufficient detail, ½ mark.

Answer 1

TUTOR TIPS

In part a, remember to explain the threats not just state them. As is often the case,

getting enough to pass is not difficult as there are more than four there, so if you can

select those that you can explain in more detail. Also of course, ensure you can suggest

safeguards for the four you select.

In part b, there are only 2 marks so only 2 benefits are needed. Note, it is BENEFITS

not ROLES, so you are looking to state advantages not just what an audit committee

does.

(a)

(i) Ethical threats

Long Association

The firm has been auditing the client for 6 years, with the same partner in

place for the entire period. There is a risk that the firm, and the partner in

particular, are too familiar with this client and might therefore have lost the

ability to be sceptical (i.e. would trust the client too much). This could lead to

Financial Statement errors going unchecked.

Tax Hearing

An advocacy threat is created if the audit firm attend the tax hearing in support

of the client. The firm would be seen as @on the side@ of the client in arguing

for no more tax to be paid – and if seen as supporting the client in this situation,

might also be seen as on the client’s side when auditing the financial

statements, and therefore potentially ignoring errors to help the directors.

Ex-Audit Staff Joining Client

A familiarity threat is created because audit staff will recognise the FD of the

client, given they used to work with him until recently. They might choose not

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to audit as thoroughly as they should (i.e. have lost some professional

scepticism) if they feel they know their ex colleague. As a result, errors made

by the new FD might go unnoticed by the audit staff.

A self-interest threat might also have arisen. If the firm’s ex-employee knew

in advance that he was going to join the client, he might have avoided finding

errors when doing audit work in the past, for fear of losing the job offer.

New Software

A self review threat is created if our firm proposes the new software for the

client, as the audit staff would be checking the output of a system we

recommended. As such, staff might be reluctant to report any mistakes caused

by the software, leading to errors staying in the financial statements.

Also a management threat is created, because directors should be making the

decision about the software. If our firm recommends the software to use,

shareholders might believe that the gap between the auditors and the directors

is too small, and might therefore question the auditors’ independence.

Discounted Services

Accepting half-price services from a client creates a self-interest threat. The

trainees are at risk of ignoring mistakes in the financial statements in order to

keep the client happy and retain their cheap lessons. Whilst no values are

given, it seems that the lessons have been going on for some time, and for

younger members of staff the value is likely to be significant.

(ii) Reducing These Threats

Long Association

The partner should be rotated off this audit as soon as possible and replaced

with another partner who has not had any recent involvement with this client.

Any other staff who have worked on this audit for at least 5 years should also

be rotated off and replaced as soon as is feasible.

Tax Hearing

It would be best to politely decline the request to attend the hearing and to

explain the reasons why to the client.

Ex Audit Staff joining Client

This is likely to be an extremely difficult issue to resolve (note – one of the

reasons why audit firms usually stop senior staff joining a client). If the audit

firm has other offices and can send an audit team from there, so that they do

not know the FD, this would help.

Given the problem, a hot review by an independent partner would also appear

wise, but in reality it might be better to consider resignation.

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New Software

The audit firm could advise on software, but should not recommend a specific

product. The final decision must rest with the client’s management, but the

audit firm could suggest criteria on which the software decision could be made,

for example.

Discounted Services

The staff involved are relatively junior, which reduces the threat (as junior staff

have relatively little impact on the audit report), but it would be best to use

different trainees on this year’s audit.

It might also be wise to remind all trainees that accepting gifts and hospitality

form clients is not allowable if the value might be seen as anything but modest,

and that any future offers of discounts should be agreed by the engagement

partner before being accepted.

(b) Benefits of Audit Committees

An audit committee should be formed of independent non-executive directors. As

such, it would help to increase the independence of both internal and external

auditors, as they would be able to report concerns to senior independent people,

rather than the executives (whose work they are auditing).

The audit committee also acts as an oversight on the quality of both internal and

external audit processes, meaning action can be taken to improve either/both if

necessary.

Since the audit committee members should have recent, relevant finance

experience, the committee also acts as a useful source of consultation and guidance

for the board in accounting matters.

Audit committees oversee financial reporting, internal controls and risk

management, so all three of these should improve over time with a committee

dedicated to them.

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Answer 2

TUTOR TIPS

In a, knowledge is being tested. No application to the story needed as the answer is

straight out of a textbook.

In b, the benefits of internal audit need to be tailored to the scenario. Think of the usual

reasons why a company would benefit from internal audit (textbook) and then look in

the story to see which of these issues are relevant to the company – which seem to be

all of them!

(a) Reliance on Management’s Expert

The client has done the valuations. If the auditor wants to use these valuations as

audit evidence, the reliability of the client’s valuations needs to be assessed by:

Assessing whether the valuer has any professional qualifications relevant to

the valuation of buildings, and if they do, verifying the qualifications are valid

Checking the valuer’s past experience in valuing buildings. For example, by

seeing if they have valued in previous years and assessing how accurate

these valuations turned out to be

Deciding how much the clear lack of independence is likely to affect the

valuations. There is no need to assess the independence of a director – by

definition they are not independent – but the auditor should assess whether

the director has an incentive not to value the buildings accurately (e.g. a

bonus tied to the value of assets)

If the above issues are considered a problem, the auditor might need to get their

own external independent expert to perform valuations instead.

(b) Benefits of Internal Audit

As the company is due to have a Listing, they are likely to need to follow corporate

governance guidance. Most codes of corporate governance recommend internal

audit, so establishing an internal audit function would help in complying with this.

Having an internal audit function will also help in giving a good impression of the

company, implying that they take controls seriously. This should help in attracting

investors.

The company has grown recently. As companies grow the directors find it harder to

manage as they cannot know everything that is happening. Having internal audit will

help to provide assurance to the directors that systems are operating effectively.

The company is not just larger, it has diversified into new areas. This will also stretch

the ability of the directors to manage the business, providing another reason for

internal audit to be in place.

One of the jobs that internal audit can do is to investigate frauds. The company has

experienced three frauds recently suggesting there are problems in control systems,

so one of the first jobs a new internal audit team could do is to identify the causes

of these incidents and seek to stop them happening again.

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Of course, the very existence of a new internal audit department would help to act

as a deterrent to future frauds, sending a message to staff that management are

taking action.

Falling profit margins suggest that the company might be becoming inefficient,

perhaps due to growth meaning systems are out of date. Internal auditors perform

value for money audits, and efficiency is one of the aspects assessed in such work,

meaning internal audit might be able to highlight where the inefficiency is happening

and be able to recommend how to resolve it.

The company has an audit committee and one of its roles is to oversee control

systems. This would be a much easier task if there is an internal audit department

to assess and test controls and report findings back to the committee.

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Answer 3

TUTOR TIPS

Another mix of knowledge and application in this question. ISA 402 is the subject of

part a, and this standard is not tested often making it difficult. However, it is only worth

2 marks, so if you cannot remember the issues with outsourcing, good exam technique

tells you not to panic and to move on to the much easier (and more regularly tested)

part b.

Part b has very few marks for each scenario given that accounting issues, materiality

and audit tests are needed. The answer below provides several examples of audit tests

but your answer only needs 2 tests, given the other 2 marks will be needed for the

other parts of the requirement. For audit tests, the easiest approach is to simply check

every fact/date/number in each story.

(a) Outsourcing

When clients outsource something which has relevance to the financial statements

it causes auditors a problem in terms of access to evidence.

In order to perform substantive tests, the auditor will need to ensure the client has

either got all paperwork back from the payroll company, or can arrange for the audit

staff to visit the payroll company to inspect the documentation.

A bigger problem relates to controls. Controls over payroll need to be assessed, but

the controls that affect the accuracy of payroll are mostly the controls at the payroll

company, not at the audit client. Assessing the payroll company’s controls will be

difficult, as the auditor has no access to this company.

The auditor might be able to get an opinion on the payroll company’s controls by

asking for a report on this from the payroll company’s own auditors, as they should

have assessed the controls as part of their own audit. Ideally the auditors need an

opinion on the effectiveness of the controls, not just a description of the system.

(b) GWC

The fire is an Event After the Reporting Period (EARP) covered by IAS 10. The fire

does not provide evidence of the condition of assets at the year end – the assets

were fine at his point – so is a non-adjusting event.

Given the damage represents in excess of 40% of profit, it is clearly material and

likely to be seen as significant enough to require disclosure. Even if insurance covers

the cost, damage to a company’s HQ would be likely to disrupt the business and

shareholders ought to be told.

Procedures to test this event will include:

Inspecting the fire service report to verify the scale of the damage and hence to

assess whether the cost appears realistic

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If the site remains damaged (the fire was over a month ago so repairs might have

been completed), an inspection of the site to assess the scale of damage and

likely impact on the business’s operations

Inspecting a copy of the insurance claim to verify it has been made, and the

amount

A review of correspondence with the insurance company sinceto assess the

likelihood of the claim being paid

Inspection of the insurance policy to assess the likelihood of the damage being

covered

Inspection of the asset register from just before the date of the fire to verify the

assets that were on site when the fire happened, to help assess whether the

$1.4m estimate is realistic

Getting a written management representation to confirm the estimate of damage

is their best estimate

OFS

The announcement before the year-end of the reconstruction is likely to be

considered a constructive obligation, as it creates the belief amongst staff,

shareholders etc that the reconstruction will probably take place. As such, IAS 37

requires that a provision is put into the financial statements.

The estimated cost of $800,000 represents 18% of profit and is therefore material.

Procedures would include:

Inspecting board minutes to verify that the decision has been taken, and that

the cost figure given appears to be correct.

Inspecting a copy of the announcement to verify it happened before the year

end, and that the details announced are the same as the board decision

Getting a breakdown of the $800,000 cost to ensure it adds up, and that all of

the likely costs (e.g. redundancies) seem to have been included

Reviewing progress of the reconstruction post year end to measure actual costs

against the estimate – given the dates in the question, the work may well have

almost been finished by the time the audit finishes.

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Answer 4

TUTOR TIPS

In a, there are only 3 modifications to an audit opinion (although one of them, the

“except for”, can arise for 2 different reasons).

In b, the link between Going Concern issues and the audit report is tested. No technique

here, it is simply something you are expected to know – but for impact on audit report

describe the changes, don’t just say “adverse” or similar.

(a) Modified Opinions

Adverse

If there are material misstatements that impact many balances in the financial

statements (“pervasive”), the auditor will give an adverse opinion stating that the

financial statements do not give a true and fair view.

Disclaimer

If there is a lack of evidence that impacts many balances in the financial statements

(“pervasive”), the auditor will issue a disclaimer of opinion, stating that “we do not

give an opinion”.

Qualified Opinion

If there is a material misstatement, or a lack of evidence, which is material but only

affects a small proportion of the balances and disclosures in the financial statements

(i.e. it is not pervasive), the auditor can highlight the problems and then state that

“except for” these issues, the financial statements give a true and fair view.

(b)

(i)

This would seem to represent a material threat to the company’s going concern

position. Relying on a single customer is a dangerous business strategy at any

time, but with the customer considering cancelling the contract there is a clear

risk that shareholders need to be aware of, and the matter should be disclosed in

line with IAS 1.

If this disclosure note is not included in the financial statements, the company

would be in breach of IAS 1 meaning the audit opinion needs to be modified.

Assuming the auditors agree that the contract is more likely to be renewed than

cancelled, and that the company is a going concern, all of the figures in the

financial statements are true and fair – it is just one missing disclosure note. As

such, an “except for” qualified opinion would seem the most likely result.

In this case, the lack of disclosure would be described in the “Basis” paragraph

above the opinion section.

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(Note – the auditor might decide that the missing disclosure note is so important

that an adverse opinion could be used, but this is a less likely answer given that

none of the numbers in the FS are wrong).

(ii)

If the auditors think the company is not a going concern, then the financial

statements have been prepared under the wrong basis – they should have been

prepared under a “break up” basis. This would make the problem pervasive, as a

lot of balances would now be wrong. Assets will need to be written down in value,

and a lot of new liabilities are likely to arise.

As such, an adverse opinion would be needed, stating that the financial

statements do not give a true and fair view.

A description of the problem would need to be given in the Basis paragraph above

the opinion.

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Answer 5

TUTOR TIPS

Part a of this question is a typical audit risk and response question. The key here is to

remember that the risks must be explained in audit risk terms – as either a material

misstatement, or a detection risk (definitely NOT as a business risk). Responses to risk

will depend on what the risk is of course, but will include substantive tests to check for

individual misstatements, increased substantive testing in general for areas where

control risk is high etc.

Part a is presented below in text – a 2 column approach could also work well.

Part b is a regularly tested area and students should be comfortable coming up with

tests, using tried and tested techniques such as AEIOU and DADA3 for ideas. But,

specific assertions are mentioned so take care to only test these – any tests for

ownership or existence will score nothing. And explain the reason for each test.

Part c is another standard type of F8 question, asking for an ISA to be explained for 5

marks. Students should ensure they are prepared to be able to do this for any of the

ISAs on the syllabus.

(a) Audit Risk and Response

The audit is a recent appointment. As such detection risk is increased because the

audit firm will not have as much knowledge and understanding of the client as they

will have in future years, meaning a greater risk that misstatements go unnoticed.

To reduce this risk, it would be wise to assign more experienced staff to this audit in

the first year, preferably those with experience of similar companies being audited.

Under IAS 38, development costs should be capitalised as intangible assets if the

projects are likely to be completed, and assuming the new products are likely to sell.

Intangible assets are at risk of overstatement because the $245,000 spent on the

now cancelled project should be in expenses.

Also, the new development is at an early stage of design, meaning any costs incurred

should also probably be in expenses not intangible assets.

To respond to this risk, the audit staff will need to verify that the project is indeed

cancelled, by confirmation from the directors and inspecting board minutes.

The extension of the warranty to 6 months means there is a risk that the provision

will be understated. IAS 37 requires a provision for the expected cost, and this will

surely have risen given there is twice as long for customers to be able to return

products. If it is calculated under the prior year assumptions, it will be understated.

To respond to this, the auditors should compare the provision with the prior year to

assess if an adjustment has been made to reflect the 6 month period.

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Several risks are created because of the new loan. Under IFRS 7, several matters

need disclosure, including repayment terms, interest rate, the nature of the security

provided etc. and there is a risk of under-disclosure as a result.

Also, the loan was mid year so there is a risk that the interest for 6 months has been

miscalculated, or has not been accrued at all.

The loan might also have been mis-classified between short term and long term

liabilities.

To respond to the above, the audit staff will inspect the loan agreement to confirm

all relevant terms and conditions, and can then recalculate the interest and verify

disclosures in the financial statements.

The company will have WIP at its year end. WIP requires someone with expertise to

assess the level of completion and there is a risk that the company and the auditors

do not have the expertise to get this right. Given it is an estimate, there is also a

risk of deliberate manipulation of the level of completion.

The most likely response to this will be for an expert to be hired to assist with the

audit work on WIP.

Being a manufacturer, the cost of finished goods will include production costs and

overheads. There is a risk that the labour costs are out of date, given that wages

would normally rise over a 6 year period, and the standard costs have not been

changed for that amount of time.

The audit response will be to compare current actual labour costs with the standards

to see how out of date they are, and if necessary to propose an amendment to

management.

(b) Substantive Tests

Completeness

Select a sample of assets seen in use on the company premises and inspect

asset register to verify they are included

Review repairs and maintenance accounts and obtain invoices for larger items

to identify whether the item is a genuine repair, or might be considered an

improvement (and hence, an asset)

Valuation

For a sample of new assets, inspect purchase invoices to verify cost has been

correctly recorded in the asset register, including all costs that brought the asset

to its condition and location for use

Compare depreciation policies in use with those in use by similar companies (e.g.

by inspecting their published financial statements accounting policies

disclosures)

For a sample of assets, recalculate the depreciation charge for the year, ensuring

it has been done in line with the policies disclosed in the financial statements

If any assets are held at valuation, inspect valuation report to verify valuation

was recent, and to agree the amount

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Assess the qualifications, experience and independence of whoever carried out

these valuations, to assess the reliability of their conclusions

Inspect the general ledger to verify that any revaluation surpluses have been

taken to separate reserve, not to profit

(c) Laws and Regulations

Responsibility for understanding laws and regulations for a company rests mostly

with those charged with the governance of that company – the directors and

management.

However, the external auditors have a responsibility to check whether the financial

statements are free from material misstatement, and if a company is breaching laws

and regulations it is likely to have accounting implications.

Any breach of a reasonably important law or regulation, caused before the year end,

is likely to mean a provision is required (IAS 37) for the fines that would be the likely

outcome. If the breach is a matter of subjectivity, a contingent liability disclosure

might be a more suitable accounting solution.

Any large breach of laws or regulations could result in such severe punishment that

the company’s going concern status could come under threat. Such threats must be

disclosed in the financial statements as per IAS 1. If the breach is very severe (or

there are new rule changes that the company might find it impossible to comply

with), the company might not even be a going concern, meaning its financial

statements would need to be produced under the alternative break-up basis.

In addition to understanding the laws and regs enough to be able to identify the risks

of misstatement caused by the above points, the auditors also have a duty to report

any breaches they find. In the first instance this should be to management, and if

serious, or if there is a concern that management are breaching rules on purpose, it

should also be reported to the audit committee.

In some cases, external reporting (e.g. to the industry regulator) might be

necessary. Legal advice might be needed if this is considered a possibility.

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Answer 6

TUTOR TIPS

Part a is a standard report on control deficiencies, but take care to note that the third

part requires tests of control. Control tests are done by an auditor to see if the

recommended improvements (the middle column of the answer) are working. Control

tests should come from AEIOU, but would normally be EIO (enquiry, observation,

inspection), perhaps using test data to assist.

There are way more deficiencies in the story than you need for the answer, so choose

the 5 that you can suggest a recommendation for, and recommend a control for which

there is an obvious control test.

For part b, there are several ISAs that require auditors to communicate with those

charged with governance – in fact the vast majority of ISAs require this, so think

through the various ISAs for ideas.

(a) Points for inclusion in a report to management

Deficiency Recommendation Test of Control

Some orders are placed by

telephone, meaning there is

a risk that the details do not

get recorded properly and

the wrong items arrive,

disrupting business.

Where urgent orders need to

be placed, they could be sent

by email with a follow up

telephone call to ensure the

supplier is aware of the

urgency, and a formal order

form then sent.

Pick a sample of GRNs and

check back to the

purchase order to verify

that there is a written

order for everyone.

The purchasing clerk seems

to do almost everything,

meaning almost zero

segregation of duties. They

could easily be making

mistakes that do not get

noticed, or ordering things

for their own personal use,

or creating fake suppliers

and diverting money to

themselves.

The clerk is clearly very busy,

suggesting that at the very

least their job role should be

divided up between 2-3 staff.

One person should start a

transaction, but someone else

(more senior) should authorise

it and someone else should

then record it. If having several

staff is not viable due to cost,

a director should at least

approve new suppliers and

agree payments.

Inspect supplier files for

evidence that a manager

has authorised new

suppliers being taken on

(e.g. by seeing a signature

on a new supplier form).

Ask client to confirm that

the clerk’s roles have been

divided up, and check HR

records to confirm new

employees have been

recruited.

There is no review of

existing suppliers, unless

one goes bust. The company

A review of suppliers used

should be carried out on an

annual basis, with quality of

Inspect supplier files to

verify there is

documentation showing

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might be missing out on

better quality suppliers if it

never chooses to look at

alternatives.

service being discussed with

the suppliers.

that such a review has

taken place.

There are no checks on

quality of goods arriving,

only quantities. There is a

risk that poor quality goods

are received, resulting in the

company’s products being

poor quality and customers

becoming upset.

The warehouse staff, or

internal quality staff, should

perform checks on a sample of

goods arriving, before they are

accepted into inventory.

Observe goods arriving to

verify that quality checks

are now taking place.

When goods arrive

overnight they are left

outside the warehouse,

creating a clear risk of theft

or damage.

The manager only reviews

totals, and only on a

monthly basis. Given the

large amount of tasks the

clerk does, their work needs

more supervision than this

in order to stop them

making mistakes or

committing fraud.

There is no review of the

purchasing budget, which

(like most things) is under

control of the clerk.

Inefficiencies, mistakes, and

fake suppliers will not be

spotted if nobody review’s

the clerk’s work.

The company should instruct

all suppliers that deliveries can

only be accepted within specific

time slots, and should refuse to

pay for any supplies unless a

member of staff signed for

them when they were

delivered.

The manager should review

this on a weekly basis and

without the detail being

aggregated into totals.

Either the budget should be

reviewed by the manager

before any purchase orders are

placed, or the manager should

construct the budget

themselves, to exert more

control over the work of the

clerk.

Inspect communication

with suppliers to verify

that this instruction has

been sent. Inspect GRNs

to verify they were signed

on all occasions.

Inspect a copy of each

week’s purchases listing to

verify a management

signature.

Inspect the budgets to

verify some involvement

by the manager.

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There is no reconciliation of

supplier statements. If

mistakes are being made by

the clerk (or the supplier)

they will not be picked up,

leading to the potential for

the company to be spending

money it does not need to

spend.

The manager should perform

monthly reconciliations of

supplier statements to the

purchase ledger account

balances, investigating any

differences they find.

Inspect copies of the

reconciliations to verify

they are done, and inspect

signatures (or enquire0 to

verify it was the manager

who did the reconciliation

and investigation.

(b) Communication with Those Charged With Governance

At the appointment stage, threats to objectivity and conflicts of interest should be

discussed with those charged with governance (TCWG), including the proposed

safeguards of the audit firm, to allow TCWG to decide if the safeguards are sufficient.

At the planning stage, audit risks, materiality and audit strategy should be discussed,

as the audit committee might have valuable input (especially on risk matters).

Any indications that the company is breaching laws and regulations (ISA 250) or is

suffering from potential fraud (ISA 240) should be communicated to TCWG so that

they can take the necessary steps to deal with these important matters.

If the auditor has problems gathering evidence, this should be communicated, so

that the audit committee can try to assist in getting this evidence to be made

available.

All material misstatements, whether corrected or as yet uncorrected, should be

disclosed to the audit committee. This allows them to judge the activities of the

Finance Director in preparing the financial statements.

At the finalisation stage, significant subsequent events, issues with the unaudited

other information, and going concern threats should all be communicated, as these

are all material issues that could cause problems in completing the audit process.

The proposed audit report must be communicated to management and the audit

committee. Especially if there is a modification, TCWG would need to understand

clearly why the auditors have reached their conclusions.

In a more general sense, anything that affects the smooth running of the audit

process should be communicated, so that it can be addressed and improved upon in

future audits.

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ACCA Paper F8

Audit and Assurance

Revision Mock Examination

June 2017

Time allowed Reading and planning: 15 minutes

Writing: 3 hours


Section A – ALL TWELVE questions are compulsory and MUST be attempted

Section B – ALL SIX questions are compulsory and MUST be attempted


During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor.

This question paper must not be removed from the examination hall.

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World Wide Ltd.

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Section A – ALL TWELVE questions are compulsory and MUST be

attempted

1. Which of the following audit procedures is a correct description of a walk

through test?

A. Selecting a purchase invoice from the sales day book to verify the amounts

agree back to the invoice, goods dispatch note and purchase order

B. Following a sales order through the client’s system to help understand how the

order is received and how it turns into a delivery

C. Selecting a Goods Despatch Note to verify a signature is present showing it

was checked back to the sales order before goods were despatched

(1 mark)

2. Your audit client Cecil Co has a draft profit before tax of $5m. The audit team have

raised the following issues as a result of their audit work:

1. One line of inventory that cost $200,000 is now obsolete, but the items remain

in the financial statements at cost

2. The company has breached its loan covenants. The loans total $3.5m and the

company has $3.7m in cash

3. One product makes up 76% of the company’s revenue. A change in legislation

means that this product will become illegal to sell worldwide from July 2015

4. A court case brought by an unhappy ex-employee is disclosed as a contingent

liability, mentioning a possible payout of $150,000. The audit team believe a

payout of $300,000 is a better estimate, and that a payout is likely.

In terms of materiality, what is the correct order of importance of the above

items (starting with the most important)?

A. 2, 3, 1 and 4

B. 3, 2, 4 and 1

C. 3, 2, 1 and 4

D. 2, 3, 4 and 1

(2 marks)

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3. Your audit firm has been approached by a potential new audit client. After some

discussion, they have invited you to become auditor of their financial statements.

Which of the following issues would make it impossible to accept their

invitation?

A. The company’s ex Finance Director, who left eight months ago, works as a

partner at your audit firm

B. One of your audit firm’s ex employees is the marketing manager at the

company

C. The company insists that the audit is done on a contingent fee basis

D. You also audit this company’s main competitor

(2 marks)

4. Auditors often used computer assisted audit techniques (CAATs) during the audit

process. The main types of CAAT are test data and audit software.

Which TWO of the following are test data?

1. Using a computer program to select all items with a particular characteristic

2. Placing a sales order to see if a customer’s computerized credit limit can be

breached

3. Trying to set up a new employee on the client’s payroll system using the payroll

clerk’s password

4. Calculating a client’s receivables days on a customer by customer basis

A. 1 and 4

B. 3 and 4

C. 1 and 2

D. 2 and 3

(2 marks)

5. Which TWO of the following are financial statement assertions relevant to

Profit or Loss items?

1. Cut-Off

2. Rights and Obligations

3. Existence

4. Completeness

A. 1 and 4

B. 1 and 2

C. 2 and 3

D. 1 and 3

(2 marks)

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6. Auditors gather evidence using tests of controls and substantive procedures.

Which of the following statements, if any, is/are correct?

1. An auditor checking that the total of sales ledger balances equals the trade

receivables balance in the statement of financial position, is a test of control

2. Attending a client’s inventory count and observing the client’s staff counting,

is a substantive procedure

A. Neither 1 nor 2

B. Both 1 and 2

C. 1 only

D. 2 only

(2 marks)

7. Which of the following statements about audit sampling are correct?

1. To comply with audit standards, every item in a population must have a chance

of being selected in the sample

2. Extrapolation involves dividing a population into sections (e.g. by age, or by

size of balance)

3. Haphazard sampling is a reliable method for selecting items

4. Sampling risk is the risk that a sample is not representative of the population

from which it is drawn

A. 1 and 3

B. 2 and 4

C. 2 and 3

D. 1 and 4

(2 marks)

8. In respect of an external auditor’s responsibilities relating to fraud at a

client, is the following statement true or false?

The external auditor should detect all material fraud.

A. True

B. False

(1 mark)

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9. Sometimes an auditor is required to use an emphasis of matter paragraph in an audit

report.

Which TWO of the following are correct in relation to an Emphasis of Matter

Paragraph in the Auditor’s Report?

1. It is used if there is an inconsistency between the unaudited information in the

Annual Report and the audited financial statements

2. It constitutes an unmodified audit opinion

3. The audit report is referred to as an unmodified report

4. It should normally be placed below the Opinion section of the audit report

A. 1 and 2

B. 3 and 4

C. 1 and 3

D. 2 and 4

(2 marks)

10. An auditor has assessed that the risk of material misstatement at a client is higher

than first thought.

How should the auditor amend the audit plan to resolve this issue?

A. Carry out more substantive testing

B. Decrease the control risk

C. Carry out more tests of control

(1 mark)

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11. The audit of Moo Co’s financial statements for the year ended 31 December 2015

has been completed; the audit report and the financial statements were signed in

late January 2016 but are not yet issued to shareholders.

One week after the audit report and financial statements were signed, the finance

director of Moo Co informed the engagement partner that he had just discovered

that a customer had gone out of business in January 2016 owing the company a

material amount. The balance had been owed since October 2015 and none of it will

be recovered.

Which of the following actions, if any, should the auditor now take as part

of their responsibilities under ISA 560 Subsequent Events?

A. No actions required as the audit report and financial statements have already

been signed

B. Request management to adjust the financial statements by writing off the

balance, verify the adjustment is made correctly, and then provide a new audit

report

C. Request management to make disclosure of this event in the financial

statements

D. Request management to adjust the financial statements by writing off the

balance, verify the adjustment is made correctly, and if correct the original

audit report does not need to be replaced

(2 marks)

12. Auditors of financial statements should keep all client information confidential in

most situations, but some exceptions exist.

In which of the following situations should the auditor NOT breach

confidentiality?

A. There is evidence to suggest the client is involved in a terrorist act

B. The client is selling products likely to harm its customers

C. The client is planning the takeover of its only competitor

(1 mark)

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Section B – ALL SIX questions are compulsory and MUST be

attempted

1. You are an audit manager at Pinnacle & Co and you are planning the audit of

Boomerang Co (Boomerang), a company that runs courses teaching people in water

sports, including surfing and diving. Your firm has audited Boomerang for the past six

years.

The directors of Boomerang are under investigation by the tax authorities and have to

attend a hearing next month. They have asked the engagement partner, Chris Chan,

to attend the hearing to speak on behalf of the company. They have pointed out that

as Mr. Chan has been engagement partner for six years, he is well placed to support

the company’s argument that they have not underpaid any taxes.

During the year, an audit manager who had worked on last year’s audit of Boomerang

left Pinnacle & Co to become the company’s Finance Director. Shortly after starting in

this new role, he decided that Boomerang needed new accounting software and has

asked your firm to recommend the software they should buy.

Two of the audit trainees from last year’s audit team were offered half-price surfing

lessons, which they accepted. Both of them are still having the lessons, and have asked

to be included in this year’s audit team.

Required:

(a) Using the information above:

(i) Explain FOUR ethical threats which may affect the independence of

your firm in respect of the audit of Boomerang; and

(4 marks)

(ii) For each threat explain how it might be reduced to an acceptable

level.

(4 marks)

(b) Explain the benefits for a company of having an audit committee.

(2 marks)

(10 marks)

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2.

(a) You have an audit client which has numerous properties. The client’s accounting

policy is to revalue its properties and one of the directors has performed the

valuations this year. Your firm is considering placing reliance on these valuations

as part of its audit evidence.

Required:

Explain what your Firm must do if it wants to place reliance on the valuations.

(4 marks)

(b) Finlayson Co is one of your audit clients. They are planning a listing on their

country’s stock exchange within the next year as they have grown rapidly. They

have also diversified operations into several new products and markets.

During the past six months, three members of staff have been sacked and

reported to police after being caught committing fraud. They only got caught

because a member of staff who was suspicious reported the matter to

management.

Whilst the company has been growing, profit margins have started to fall. The

directors are concerned about inefficiency creeping in because of the size of the

company. The company has recently established an audit committee, but has no

internal audit function.

Required:

Explain why an internal audit department might be of benefit to Finlayson Co.

(6 marks)

(10 marks)

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3.

(a) Your firm audits the financial statements of Merlion Co, a company with a large

number of employees. The directors of Merlion Co are considering outsourcing

their payroll function to a local specialist firm called Payroll Plus Co, and have

asked what impact this might have on your audit process.

Required:

Explain the impact this outsourcing decision would have on your audit of the

financial statements of Merlion Co.

(2 marks)

(b) You are currently reviewing the audit files for several of your clients for which

the audit fieldwork is complete. The audit seniors have raised the following

issues:

GWC Co.

GWC Co has a year end of December 31st 2015. The draft financial statements

show a profit of $3.4m. On January 26th 2016 the company’s headquarters were

severely damaged by a fire. Damage has been estimated at $1.4m, and an

insurance claim was submitted on February 4th 2016.

OFS Co.

OFS Co has a year end of December 31st 2015 and the financial statements show

a profit of $4.4m. In a board meeting three weeks before the year end the

directors decided that a major company reconstruction was needed and they

announced this to staff and shareholders on the following day. The reconstruction

was expected to take three months and to cost approximately $800,000, and

work began on this in mid January 2016.

Required:

For each of the scenarios above:

(i) Discuss the accounting issues and assess the materiality of the

situation; (4 marks)

(ii) Suggest further audit procedures that should now be performed to

help the audit team come to a conclusion on the correct accounting

treatment.

(4 marks)

(10 marks)

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4.

(a) Describe THREE ways in which the audit opinion can be modified within

an audit report on a set of financial statements.

(3 marks)

(b) MBS Co is an audit client of your firm. The company supplies fruit and vegetables

to a major national supermarket chain. One of the terms of the deal is that they

are not allowed to supply any other companies, so the supermarket chain is their

only customer. The supermarket chain has told MBS Co that their annual

contract, due for renewal shortly after the end of your audit, is at risk of not

being renewed.

The directors believe that the contract will probably not be lost, and that even if

it was not renewed they would be able to find other customers quickly to replace

the supermarket chain. Having assessed the situation, the audit team agrees

with the directors.

The above matter is not reflected in the financial statements of MBS Co.

Required:

(i) Describe the accounting amendment needed to the financial

statements of MBS Co and the impact on the audit report if this

amendment is not made. (4 marks)

(ii) If the audit firm changes its mind and decides that MBS Co is not a

going concern, and there are no adjustments to the financial

statements, explain the impact on the audit report. (3 marks)

(10 marks)

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5. Your firm has recently been appointed as the auditor of the financial statements of

Gusto Co, a company which designs, develops and manufactures bicycles. The

company has existed for over 60 years and has made profits consistently over this

period. The market for bicycles is relatively stable, with older models continuing to sell

for many years even when newer models are introduced.

The company’s year-end is March 31st 2016 and you have been asked to help with the

audit planning.

In September 2015 the company started development work on a new model of bicycle,

and so far has capitalized development costs of $245,000 for this project. Recent

market research results have suggested that the model will not sell as well as

previously thought, and the board decided last week to scrap the project. A totally

different new model is in the early stages of design and development work will begin

in June 2016.

Historically, all of the company’s bicycles were sold with a 3 month warranty covering

basic repair costs. From December 2015, the company has extended this to cover 6

months on all new sales.

The company took out a secured loan of $1m at an interest rate of 4% on October 1st

2015. The loan is repayable in full on October 1st 2018.

Much of the production process, especially in the final stages, is labour intensive. At

any point in time the company has significant work in progress and labour costs form

a significant part of the production cost. Finished bicycles are valued at standard cost.

The standard costs were set in 2009 and are due for review next year.

Required:

(a) From the above information, explain FIVE audit risks that arise and

describe the auditor’s responses to these risks, in planning the audit of

Gusto Co. (10 marks)

(b) Describe FIVE substantive audit tests that you would plan to carry out

to test the completeness and valuation of the company’s property, plant

and equipment. (5 marks)

(c) Explain the auditor’s responsibilities in relation to the laws and

regulations that Gusto Co. are required to follow. (5 marks)

(20 marks)

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6. You are the auditor of Canton Co., a manufacturer of household appliances such as

kettles, toasters and microwave ovens, and have been provided with the following

description of the purchasing system.

Purchase Ordering and Receipt of Goods

The majority of purchase orders are done in writing, but when parts are needed

urgently the orders are sometimes done by telephone. The company uses a large

number of suppliers, many of whom have supplied the company for many years, and

one purchasing clerk places all of the orders. During the last year two suppliers closed

down, but the purchasing clerk quickly found two replacement companies to supply

the necessary parts. The clerk agreed prices and other terms and deliveries have

already started to arrive. Unless a supplier goes out of business, the companies who

supply Canton Co. are never changed or reviewed.

When goods arrive the quantities are checked back to the original order by the

purchasing clerk and then the goods are booked into the warehouse. The purchase

clerk signs the goods received note to evidence that the delivery was checked to the

order. Orders sometimes arrive overnight when no company staff are present, and

suppliers unload the items outside the warehouse gate for the staff to deal with in the

morning when they arrive at work.

A purchasing manager reviews total purchasing figures on a monthly basis and

compares them to the purchasing budget produced by the purchasing clerk. The

manager does not review the budget when the clerk prepares it each year.

Invoicing

When suppliers send invoices, the purchasing clerk checks the details back to the

orders to verify prices are as expected and then transfers the money to the supplier at

the month end. All suppliers send monthly statements to the company but the

purchasing clerk just places them on the supplier files, as he is too busy to do anything

else with them.

Required:

(a) In respect of the purchasing system of Canton Co:

(i) Describe and explain FIVE deficiencies;

(ii) Recommend a control to address each of these deficiencies; and

(iii) Describe a test of control your audit firm would perform to assess

if each of these controls is operating effectively.

Note: The total marks will be split equally between each part

(15 marks)

(b) Other than control deficiencies, describe FIVE other matters that

external auditors should communicate with those charged with

governance at a client. (5 marks)

(20 marks)

End of Question Paper

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Paper F9

Performance Management

Revision Mock

June 2017

Answer Guide

Health Warning!

How to pass Attempt the examination under exam conditions

BEFORE looking at these suggested answers.

Then constructively compare your answer,

identifying the points you made well and

identifying those not so well made.

If you got basic definitions and rules wrong: re-

revise by re-writing them out until you get them

correct.

How to fail Simply read or audit the answers congratulating

yourself that you would have answered the

questions as per the suggested answers.

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World Wide Ltd.

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Section A

Marking scheme: 2 marks each

B

(1 + N) = (1 + R) × (1 + I)

R = (1.18 / 1.06) – 1 = 11.32%

C

Initial outlay = PV/PI = 50/2 = $25 million

IRR to perpetuity = (Annual cash flows/Initial outlay) × 100%

= (10/25) × 100% = 40%

A

D

Account receivable = 2/12 × 240,000 = $40,000

Inventory = 3/12 × 120,000 = $30,000

Current assets $70,000

Current liability = 70,000/1.4 = $50,000

B

Statement (i) is true and Statement (ii) is false. The profitability index should only

be used to rank projects where the projects are divisible.

A

EOQ = (2 × 25,000 × 10)/2 = 500 units

Total cost at EOQ $

Purchase cost 25,000 × £4 100,000

Total ordering cost 10 × 25,000/500 500

Total holding cost 2 × 500/2 500

Total cost 101,000

D

Expected return = 4% + 1·5(9% – 4%) = 11·5%

Predicted share value = 30/0·115 = 261 cents

B

C

A

A

Dividend per share = EPS × Dividend pay-out ratio = 25p × 0·60 = 15 cents

Share price = EPS × P/E ratio = 25p × 20 = 500 cents

Dividend yield = (DPS/MV of share) × 100% = (15/500) × 100% = 3·0%

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A

Original share (4 × $6·00) 24·00

Rights share (1 × $6·00 × 0·60) 3·60

5 27·60

Ex-rights price ($27·60/5) 5·52

Value of rights per original share $6.00 – $5.52 = $0·48

B

The first statement is correct. However, futures contracts are standardised.

D

Statement (i) is incorrect. An invoice discounter has no contact with the client’s

customers. Statement (ii) is incorrect. A bank bill is one that is accepted on a

customer’s behalf. It is a trade bill that may be discounted. Statements (iii) and (iv)

are correct.

A

The question asked for the effect on cost of EQUITY.

D

Profit after tax = 20 m × $1·00 (i.e. 5 × $0·20) = $20 m

$m

Net profit before interest and taxation (6x) 30·0

Less interest (x) 5·0

Net profit before taxation (Y) = (5x) 25·0

Less taxation (0·2Y) 5·0

Net profit after taxation (0·8Y) 20.0

C

The company is selling euros and so the higher three months forward rate applies.

Hence:

Sterling receipts = 200,000/1·4897 = £134,255

D

The cost of loan capital is: 10% (6·0/8·0) × (1 – 0·20) = 6%

WACC is calculated as follows:

12% = [(8/20) × 6%] + [(12/20) × X%]

0·6X = 9·6%

X = 16%

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C

The first statement is incorrect. It reflects the residual view of dividends. The second

statement is correct.

D

Financial gearing increases the risk of share price and earnings per share volatility

as well as loan default.

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Section B

Answer 1


Analyse the financial statements for the symptoms of overtrading.

This should include calculation of some ratios such as inventory turnover period,

receivable and payable turnover period, and liquidity ratios.

Calculate percentage increase in sales, inventory, receivables, and payables.

Discuss whether the company shows signs of overtrading, relating your discussion

with the ratios and percentages calculated.

Marking Guide

Marks

Financial analysis 4–5

Discussion of overtrading 4–5

Conclusion 1

Max 10

Financial analysis

Turnover 2014 1.278 × $4.5 million = $5.751 million

Cost of sales 2014 40% × $5.751 million = $2.3004

Turnover/Revenue increase

(Given)

= 27.8%

Non-current assets increase 4,325/3,775 = 14.6%

Inventory increase 575/475 = 21%

Receivable increase 950/550 = 72.7%

Payable increase 625/450 = 38.9%

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2014 2013

Current

ratio

1,625/1,050 1.55 1,275/450 2.83

Quick ratio (1,625 – 575)/1,050 1.00 (1,275 – 475)/450 1.78

Inventory

turnover

period

(575/2,300) × 365

91 days

(475/1,750) × 365

99 days

Receivables

turnover

period

(950/5,751) × 365

60 days

(550/4,500) × 365

45 day

Payables

turnover

period

(625/2,300) × 365

99 days

(450/1,750) × 365

94 days

Revenue to

working

capital

5,751/(1,625 − 1,050)

10 times

4,500/(1,275 − 450)

5.5 times

Revenue to

non-current

assets

5,751/4,325

1.3 times

4,500/3,775

1.2 times

Discussion

Overtrading is the term applied to a company which rapidly increases its turnover without

having sufficient capital backing, hence the alternative term “under-capitalisation”. It

arises when a company has too small a capital base to support its level of business

activities.

Overtrading in often associated with rapid increase in turnover and Aston Co has

experienced rapid increase in revenue of 27.8% in a growing market whiles cost of sales

is also up by 31.4%. There is also a sharp increase in revenue to non-current asset ratio

from 1.19 to 1.33 times, and revenue to net current assets from 5.5 to 10 times. Output

increases are obtained by more intensive utilisation of existing non-current assets, and

growth tends to be financed by more intensive use of working capital.

In overtrading situation the current ratio and quick ratio decreases and the current ratio

and quick ratios have decreased from 2.83 to 1.55 and 1.78 to 1.00 respectively.

Overtrading could be indicated by increase in inventory days. However, the inventory

days fell from 99 to 91 days.

In overtrading situation the entity increases its reliance on short-term sources of finance

such as overdraft and accounts payable. The payable days increased from 94 to 99 days

indicating the entity’s inability to pay its suppliers early. The entity’s cash position fell by

£150,000 and overdraft increased from 0 to £425,000 indicating over reliance on short-

term finance.

Overtrading could also be indicated by deterioration in receivable days. Receivable has

increased by 72.7% compared to increase in revenue of 27.8%, much explained by the

increase in receivable days from 45 to 60 days showing that the increased in revenue may

have been achieved through provision of generous credit facilities given to customers.

In conclusion, Aston Co is exhibiting the signs of overtrading, but the evidence can be

more clearly shown if industry average figures are available as benchmark.

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Answer 2


Part (a)

WACC can be used as the discount factor to appraise a project if it reflects the

systematic business and financial risk of that project.

Discuss business risk, financial risk and the size of the project as the reasons to

justify the usage of WACC.

Part (b)

Use company A and B as the proxy companies.

Un-gear the beta of company A and B using their respective debt/equity proportions.

Calculate the average un-geared/asset beta for the industry as the sum the two

asset betas and divide by two.

Re-gear the average asset/ungeared beta using the debt/equity proportion of DVA.

Calculated the project specific cost of equity using the CAPM formula provided on

the formula sheet.

Marking Guide

Part (a) Marks

Discussion of business risk 2

Discussion of financial risk 2

Discussion of size of project 1

Max 5 marks

Part (b)

Un-geared beta: company A 1

Un-geared beta: company B 1

Average un-geared beta 1

Re-geared beta 1

Project specific cost of equity 1

Max 5 marks

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(a) The cost of capital to be used as the discount factor to appraise a project should reflect

the systematic business and financial risk of that project.

Business risk

WACC can be used in investment appraisal provided that the business risk of the

proposed investment is similar to the business risk of existing operations. Essentially

this means that WACC can be used to evaluate an expansion of existing business.

As DAV is evaluating a new investment in an unrelated industry an area in which it has

not previously been involved the business risk of the investment project will be

different from the business risk of existing operations and therefore the current WACC

will not be appropriate as it will not incorporate this additional business risk, hence a

project specific discount rate that reflects the business risk of the new investment

project should be used.

Financial risk

WACC can be used in investment appraisal provided that the financial risk of the

proposed investment is similar to the financial risk of existing operations. This means

that financing for the project should be raised in proportions that broadly preserve the

capital structure of the investing company.

Size of project

WACC can also be used in investment appraisal if the size of the proposed investment

is small in relation to the size of the company. If the project is large relative to the size

of the company then this will cause a change in the perceived risk of the company,

making the existing WACC inappropriate to be used as a discount factor.

(b) Un-gear (asset) beta:

A = 1.3 × (90/(90 + 10 × 0.7)) = 1.21

B = 1.4 × (80/(80 + 20 × 0.7)) = 1.19

Average asset beta = 1.21 + 1.19/2 = 1.2

Re-gear the asset beta to reflect the debt equity proportion of the company;

1.2 = Bg × (60/60 + 40 × 0.7)

Bg = 1.76

Ke = 6% + 1.76(4%) = 13.04%

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Answer 3


Part (a)

Discuss at least four attractions of convertible debt as compared to straight debt

like bank loans and loan notes.

Remember that tax savings on interest is applicable to both convertible and straight

debt and should not be discussed.

Part (b)

Calculate conversion value as the market price of ordinary shares in five years’ time

multiply by the conversion ratio of 20 shares.

Market value is the present value of the interest and conversion value using the cost

of debt as the discount factor.

Floor value is the present value of interest and redemption value using the cost of

debt as the discount factor.

Conversion value is the difference between the market value of the convertible debt

and the current conversion value (current market share price × conversion ratio

shares of 20).

Marking Guide

Part (a) Marks

1 mark for each correct point discussed up to a maximum of 4 marks 4 marks

Part (b)

Conversion value 1

Market value 2

Floor value 2

Conversion premium 1

Max 6 marks

(a) Convertible securities are fixed return securities (usually debentures and preference

shares), that has the right to be converted into ordinary share at the option of the

holder within a pre-determined period at a pre-determined rate. Once converted, they

cannot be converted back into the original fixed return security.

Convertible securities are fixed return securities (usually debentures and preference

shares), that has the right to be converted into ordinary share at the option of the

holder within a pre-determined period at a pre-determined rate. Once converted, they

cannot be converted back into the original fixed return security.

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Convertible security is much cheaper than equity finance and ordinary debt. The

interest rate on convertible debt will be lower than the interest rate on ordinary

debt such as a bank loan because of the value of the option to convert.

Liquidity position is preserved if conditions are favourable and the debt is

converted into shares. If the debt is converted into ordinary shares, it will not

need to be redeemed, i.e. self-liquidation has occurred. A bank loan of a similar

maturity will need to have all of the capital repaid.

Gearing will increase with a bank loan for the time that the debt is outstanding,

and gearing will then return to its previous level when the bank loan has been

paid off. Gearing also increases when convertible debt is issued, but if conversion

occurs, the gearing will fall not only because the debt has been removed, but will

fall even further because equity has replaced the debt.

Fewer restrictive covenants/conditions on the issue of convertibles debt than on

ordinary debt.

It is a back door of issuing shares when share prices are depressed. It may be

possible to issue convertible debt even when ordinary debt such as a bank loan

is not attractive to lenders, since the option to convert offers a little extra that

ordinary debt does not. This is the option to convert in the future, which can be

attractive to optimists, even when the short- and medium-term economic outlook

may be poor.

(b)

Market value

Expected share price in five years’ time = 5.35 × 1·055 = $6·83

Conversion value = $6·83 × 20 = $137.

Year Cash flow DF (7%) PV (£)

Interest 1–5 8 4.100 32.80

Conversion value 5 137 0.713 97.68

130.48

Floor value

Year Cash flow DF (7%) PV (£)

Interest 1–5 8 4.1 32.80

Redemption value 5 100 0.713 71.3

104.10

Conversion premium

Market value of convertible debt = 130.48

Conversion value at date of issue = ($5.35 × 20) = 107.00

= 23.48

Conversion premium per share = 23.48/20 = $1.174 per share

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Answer 4


Part (a)

NPV should be calculated as the present value of future relevant cash flows

(discounted using the appropriate cost of capital) less the initial investment.

The $4.5 including the consultancy fee is sunk as it has already been incurred and

as such is irrelevant to cash flow. It should be ignored.

Depreciation of $1.5 is irrelevant cash flow as it does not involve movement of cash.

Tax is payable one year in arrears. Capital allowances are on reducing balance basis.

Working capital should be included in year zero and recovered in year four.

Comment on the financial acceptability of the project.

Part (b)

Explain at least 3 reasons for soft capital rationing.

Explain at least 3 reasons for hard capital rationing.

Marking Guide

Part (a) Marks

Sales 1

Variable cost 1

Fixed cost 1

Tax 2

Tax saved on capital allowances 3

Residual value 1

Working capital recovery 1

NPV 1

Comment 1

Max 10 marks

Part (b)

Soft capital rationing 2–3

Hard capital rationing 2–3

Max 5 marks

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(a)

Years 0 1 2 3 4 5

$000 $000 $000 $000 $000 $000

Sales 15,750 22,750 18,000 10,000

Variable cost 2,700 3,900 3,600 2,400

Fixed cost (7.6 - 1.5) 6,100 6,100 6,100 6,100

6,950 12,750 8,300 1,500

Tax (30%) (2,085) (3,825) (2,490) (450)

Tax saved on capital allowances 638 478 359 475

Plant and equipment (8,500)

Residual value 2,000

Working capital (1,200) 0 0 0 1,200 0

Net cash flows (9,700) 6,950 11,303 4,953 2,569 25

DF (12%) 1 0.893 0.797 0.712 0.636 0.567

Present values (9,700) 6206 9008 3527 1634 14

Net present value ($000) $10,689

Since the NPV is positive the project should be undertaken.

Workings

Sales

Year 1 2 3 4

Sales units (000) 450 650 600 400

Selling price 35 35 30 25

Sales ($000) 15,750 22,750 18,000 10,000

Variable costs

Year 1 2 3 4

Sales units (000) 450 650 600 400

Variable cost per unit 6 6 6 6

Total variable cost 2,700 3,900 3,600 2,400

Tax savings on capital allowances

Year 1: $8,500 × 25% × 30% = 638

Year 2: 638 × 75% = 478

Year 3: 478 × 75% = 359

Year 4: difference = 475

Total benefits (8,500 – 2,000) × 30% = 1,950

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(b) Capital rationing occurs whenever there is a budget ceiling or a market constraint on

the amount of funds which can be invested during a specific period of time. It is a

situation where there are insufficient funds to finance all projects with positive net

present value.

There are two causes of capital rationing:

Soft or internal capital rationing

Soft capital rationing is often used to refer to situation where, for various reasons, the

firm internally imposes a budget ceiling on the amount of capital expenditure.

It occurs due to internal factors such as:

Management may be reluctant to issue additional share capital because of the

concern that this may lead to a dilution in control

Management may be unwilling to issue share capital if it will lead to a dilution in

earnings per share.

Management may not want to raise additional debt capital because they do not

want to be committed to large fixed interest payment or due to the concern of

gearing.

There may be a desire within the company to limit investment to a level that can

be financed solely from retained earnings.

Hard or external capital rationing

Hard capital rationing occurs whenever there is a market constraint on the amount of

funds which can be invested during a specific period of time.

This occurs due to external factors such as:

Credit crunch

Raising money through the stock market is not possible because share prices are

depressed.

There may be restriction on bank lending due to government controls

Lending institutions may consider an organisation to be too risky to be granted

further loan facility

The cost associated with making small issues of capital may be too great

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Answer 5


Part (a)

TERP should be calculated as the weighted average of the cum-rights market value and

the proceeds from the rights issue.

The proceeds from the rights issue should be calculated as:

The difference between the amount required and the bank loan,

Converted into dollars using the spot exchange rate.

The number of shares issued in the rights issue will be calculated as:

Proceeds from the rights issue divided by the rights issue price.

Part (b)

(i)

The effect of the UK investment on the earnings per share of TRA Co can be evaluated

by comparing:

the earnings per share before (current) and

after (revised) the UK investment.

Earnings per share is calculated as the earnings divided by the number of shares.

The earnings after the UK investment is the sum of the earnings from the American

operations and that of the UK operations.

The earnings of the UK operations should be calculated as:

the operating profit, less interest on the loan, converted at the exchange rate on

30th September 2013 and less American tax.

The exchange rate at 30th September 2013 should be estimated using the

purchasing power parity theory, using the given inflation rates of the two countries.

The revised earnings per share will then be calculated as:

the revised earnings divided by the revised number of shares (current number of

shares plus rights issue shares).

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(ii)

The effect of the UK investment on the wealth of the shareholders of TRA Co can be

evaluated by comparing:

share price after the rights issue(TERP) and market price after (revised) the UK

investment.

Market price can be calculated as the price earnings ratio multiplied by the earnings

per share.

Given the current market price and current earnings per share calculated, calculate

the current price earnings ratio.

Assuming that the price earnings ratio remains constant, the revised share price

should be calculated as the revised earnings per share multiplied by current price

earnings ratio.

Comment on your findings. If the market price after the UK investment is higher than

the TERP, then the UK investment is acceptable as shareholders wealth is increased.

Marking Guide

Part (a) Marks

Amount raised from rights issue from America in $ 1

Number of rights issue shares 1

TERP 2

Max 4

Part (b)

Current profit before interest and tax 1

Current earnings per share 1

Current P/E ratio 1

Interest on UK 10% loan 1

Exchange rate at 30/09/2013 using PPPT 1

$ profit after interest from UK operations 1

Revised profit after tax 1

Revised EPS 1

Revised market price 1

Comment 3 Max 11 marks

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(a)

Amount required £200

Bank loan £100

Rights Issue £100

Exchange rates ($2/£1) 2

Amount to be raised from rights issue from America $200

Number of rights shares ($200/$5) = 40 shares

TERP calculation

150 × 7 = 1,050

40 × 5 = 200

190 1,250

TERP = 1,250/190 = $6.58

(b)

Current EPS (30 September 2014)

$million

Profit before interest and tax 80

Tax (25%) 20

PAT 60

Current number of shares 150

Current EPS (PAT/No. of shares) = 40.00 cents

Current price–earnings ratio (P/E) MP/EPS = 7.00/0.4 = 17.5 times

Revised EPS (30 September 2015)

£million £million

Profit before interest and tax from America operations 80

Operating profit from UK operations 25

Interest on loan (10% × 100) 10

15

Exchange rate = $2 × (1.1/1.08) 2.037

Profit before tax from UK operations 30.56

Total profit before tax in America 110.56

Taxation (25%) 27.64

Profit after tax 82.92

Revised Earnings per share 82.92/190 = 43.64 cents

Using constant P/E ratio, the revised market price = 43.64 × 17.5 = $7.64

Commented [NN1]:

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Comment:

The earnings per share increased from 40 cents to 43.64 cents due to the UK

operations. This is because the increase in the earnings from the UK operations was

more than the proportionate increase in number of shares from the rights issue.

The current market price of the company is $7 and after the rights issue the price

(TERP) reduced to $6.58. The reduction in market price of the shares does not reduce

the shareholders wealth as the reduction is compensated by increased number of

shares. After investing in the UK operations, the share price increased to $7.64 and

therefore increase in shareholders wealth by $1.06 (7.64 – 6.58).

ACCA

Paper F9

Performance Management

Revision Mock Questions

June 2017

Time allowed 15 minutes Reading and planning

3 hours Writing


Section A – ALL 20 questions are compulsory and MUST be attempted

Section B – ALL FIVE questions are compulsory and MUST be

attempted


During reading and planning time only the question paper may

be annotated. You must NOT write in your answer booklet until

instructed by the supervisor.

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World Wide Ltd.

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Section A – ALL questions are compulsory and MUST be attempted

A company has a nominal cost of capital of 18% per annum. If inflation is 6% each

year, the company’s real cost of capital to the nearest 0.01% is?

25.08%

11.32%

10.45%

10.08%

CRT plc evaluates an investment project that has an initial outlay followed by annual

net cash inflows of $10 million throughout its infinite life. The evaluation of the inflows

produced a present value of $50 million and a profitability (present value) index of 2·0.

What is the internal rate of return and initial outlay of this project?

IRR Initial outlay

% $m

A. 20 25

B. 20 100

C. 40 25

D. 10 100

The validity of using the existing weighted average cost of capital as the appropriate

discount rate for deducing the net present value of a project rests on a number of key

assumptions. These include the following:

The investment project has the same level of risk as those projects normally

undertaken by the business.

The investment project is small in relation to the size of the business.

Which one of the following combinations (true/false) concerning the above

statements is correct?

Statement

(i) (ii)

A. True True

B. True False

C. False True

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Consider the following information relating to Marcus Ltd.

$

Sales 240,000

Cost of sales 120,000

Receivable turnover period 2 months

Inventory turnover period 3 months

Payables turnover period 1 month

Current ratio 1.4 times

Marcus Ltd current asset consists of account receivable and inventories whiles its

current liabilities consists of account payables and overdraft.

What is the value of receivables and current liabilities?

Receivables Current liabilities

A. $50,000 $40,000

B. $25,000 $30,000

C. $30,000 $25,000

D. $40,000 $50,000

Where there is capital rationing, the profitability index (PI) may be used to rank

investment projects with a positive net present value. It has been claimed that using

the PI is appropriate only when:

Capital rationing is for a single period.

The investment projects are indivisible.

Which ONE of the following combinations (true/false) concerning the above


Statement

(i)

Statement

(ii)

A. True True

B. True False

C. False True

D. False False

A retailer sells 25,000 units of a particular product each year and the demand for the

product is even throughout the year. The purchase price of the product is $4 per unit.

The cost of placing each order for the product is $10 and the cost of holding one unit

in stock for one year is $2.

The supplier has offered a 5% discount for order of 1000 unit or more.

The economic order quantity (EOQ) and the total annual cost at economic

order quantity are?

Economic order quantity Total annual cost at EOQ

A. 500 units $101,000

B. 500 units $101,500

C. 600 units $101,000

D. 600 units $101,500

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QTY plc pays an annual dividend of 30 cents per share to shareholders, which is

expected to continue in perpetuity. The average rate of return for the market is 9%

and the company has a beta coefficient of 1·5. The risk-free rate of return is 4%.

What is the expected rate of return for the shareholders of the company and

the predicted value of the shares in the company?

Expected

rate of

return (%)

Predicted

value

(cents)

A. 23·5 705

B. 17·5 171

C. 16·5 182

D. 11·5 261

Which one of the following statements is correct?

A stock market that is efficient in the semi-strong form cannot be efficient in the

weak form

A stock market that is efficient has share price movements occurring on a random

basis

A stock market that is efficient in the strong form is one in which investors cannot

make any profit

A stock market that is efficient will have regular, recurring patterns of share price

movements.

The group or individuals whose interests are directly affected by the activities

of a company are called?

Agents

Investors

Stakeholders

Shareholders

Consider the following two statements concerning non-for-profit (NPF) organisations:

An NFP organisation has service-related outputs that are difficult to measure in

quantitative terms and so it focuses on performance measures linked to input, e.g.

minimising the input cost for a given level of output.

A large charity seeks to raise as much funds as possible in order to achieve its

charitable objectives, which are non-financial in nature.

Which one of the following combinations (true/false) relating to the above


Statement

(i)

Statement

(ii)

A. True True

B. True False

C. False True

D. False False

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EDO plc has $1 ordinary shares in issue. For the year just ended, the company

generated earnings per share of 25 cents. The dividend pay-out ratio for the year is

60% and the price/earnings ratio is 20 times. Ignore taxation.

What is the gross dividend yield ratio of the company?

3·0%

5·0%

8·3%

15·0%

Columbus plc has 10 million shares in issue and has a market capitalisation of $60

million. The company has recently announced a one-for-four rights issue at a discount

of 40% on the current market value.

What is the theoretical value of the rights attached to each original share?

$0·48

$0·60

$1·38

$1·92

Consider the following statements concerning currency risk hedges:

A currency swap may be used to hedge for a longer period than that offered by

forward exchange contracts.

A futures contract can be customised to fit the particular needs of the client.



Statement

(i)

Statement

(ii)

A. True True

B. True False

C. False True

D. False False

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Consider the following statements concerning sources of finance.

Invoice discounting requires the discounter to invoice the client’s customers for

goods or services provided.

A bank bill offers a bank customer the opportunity to discount the bill of exchange

at the bank.

Operating leases are rental agreements where the lessor retains responsibility for

servicing and maintaining the leased equipment.

‘Junk bond’ is a term for bonds that have been given a rating by a credit-rating

agency that is below investment grade.

Which two of the above statements are correct?

(i) and (ii)

(i) and (iii)

(ii) and (iv)

(iii) and (iv)

Three views concerning the effect of loan capital on the capital structure of a business

are:

The traditional view.

The Modigliani and Miller (without taxes) view.

The Modigliani and Miller (with taxes) view.

According to each view, what will be the effect (rise/fall/stay constant) on

the cost of equity when the level of loan capital increases?

Traditional

view

Modigliani and Miller

(without taxes) view

Modigliani and Miller

(with taxes) view

A. Rise Rise Rise

B. Fall Stay constant Rise

C. Rise Stay constant Fall

D. Fall Fall Fall

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The financial performance of EBA Co for the most recent year produced the following

ratios:

Dividend cover 5 times

Interest cover 6 times

Dividend per share $0·20

The company has ordinary share capital of $10m made up of $0·50 ordinary shares.

The company pays tax at 20%.

What is the net profit before interest and taxation of the company?

$1·2m

$15·0m

$28·8m

$30·0m

A UK company expects to receive €200,000 in three months’ time for goods sold to a

German customer and wishes to hedge the currency risk by taking out a forward

contract. The following rates have been quoted:

Spot rate 3 months forward

Euro per £ 1·4925–1·4985 1·4890–1·4897

If the forward contract is taken out, what are the sterling receipts for the UK

company?

£133,467

£134,003

£134,255

£134,318

LIA Co has irredeemable loan stock with a nominal value of $6m on which it pays

interest at the rate of 10% per year. The market value of the loan stock is currently

$8 million and the corporation tax rate is 20%. The company also has equity shares in

issue with a market capitalisation of $12 million. The weighted average cost of capital

of the company is 12%.

What is the company’s cost of equity?

13·3%

14·7%

15·0%

16·0%

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Consider the following statements concerning dividend policy.

According to the Modigliani and Miller (without taxes) view of dividend policy:

dividends should be distributed only when investment opportunities are exhausted.

the value of a business is determined by the earning power of its assets rather than

by its dividend policy.



Statement

(i) (ii)

A. True True

B. True False

C. False True

D. False False

Consider the following statements concerning financial gearing.

Higher financial gearing increases the risks of:

share price volatility

earnings per share volatility

loan default

Which of the above statements are correct?

(i) and (ii)

(i) and (iii)

(iii) only

(i), (ii) and (iii)

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Section B – ALL FIVE questions are compulsory and MUST be

attempted

1. The financial statement of Aston Co for 2013 and 14 contains the following statement

of financial position.

Statement of financial position

2014 2013

$000 $000

Non-current assets 4,325 3,775

Current assets

Inventory 575 475

Account receivables 950 550

Cash 100 250

Total current assets 1,625 1,275

Total assets 5,950 5,050

Total equity 4,050 3,750


10% secured Bond payable 2018 850 850

Current liabilities

Account payables 625 450

Bank overdraft 425 0

Total current liabilities 1,050 450

Total equity and liabilities 5,950 5,050

Aston Co achieved a turnover of $4.5 million and cost of sale of $1.75 million in 2013.

In 2014 the turnover increased by 27.8% due to a rapid growth in the industry in which

Aston operates as a result of general economic recovery. The respective gross profit

margin was 60%.

Required:

Evaluate and discussion on whether Aston Co could be classified as

overtrading.

(10 marks)

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2. DVA Co is considering a new investment in an unrelated industry. The capital structure

of the company consists of 60% equity and 40% debt. The following information has

been identified about companies operating in the industry sector of the new

investment.

Company Equity beta (βe) Equity: Debt

A 1.3 90:10

B 1.4 80:20

Additional information:

Equity beta of DVA Co 1.25

Risk free rate of return 6%

Market risk premium 4%

Tax rate 30%

Required:

Discuss the circumstances under which the weighted average cost of

capital can be used to appraise a new investment. (5 marks)

Calculate the project specific cost of equity for the new project.

(5 marks)

(10 marks)

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3. Fairvalue plc provides cleaning services to offices, hotels and restaurants. Its shares

are currently trading at $5.35 per share and this is expected to increase by 5% per

year for the foreseeable future. It also has in issue 8% bonds which are redeemable

at their par value of $100 in five years’ time. Alternatively, each bond may be

converted on that date into 20 ordinary shares of the company. The company has a

cost of debt capital of 7% per year.

Required:

Discuss the attractions to a company of convertible debt compared to

straight debt as a source of finance. (4 marks)

Calculate the following current values for each $100 convertible bond:

(i) market value;

(ii) floor value;

(iii) conversion premium. (6 marks)

(10 marks)

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4. BXN plc is a medical research business that has recently patented a device which

enables medical professionals to administer vaccinations without the use of needles.

The new device has incurred total costs to date of $4·5 million, of which $0·5 million

relates to consultancy fees that are due for payment in three months’ time. The device

is now fully developed and ready to launch.

The manufacture and sale of the device would involve immediately purchasing of plant

and equipment at a cost of $8·5 million, which would then be installed in part of the

company’s premises that is currently unused. Production of the new device could begin

immediately and over the expected four-year life of the device, sales are forecast to

be as follows:

Year 1 2 3 4

Forecast sales (000’s units) 450 650 600 400

Expected selling price per unit $35 $35 $30 $25

There would be an immediate injection of working capital of $1·2 million, which could

be released at the end of the expected life of the device. The plant and equipment

would have no further use at the end of the four-year period and could be sold for an

estimated $2·0 million at that point.

The variable costs associated with producing and selling the device are estimated at

$6 per unit and estimated annual fixed costs are as follows:

$m

Manufacturing 4.4

Selling, administration and distribution 3.2

7.6

Manufacturing fixed costs include an annual depreciation charge of $1·5 million. The

plant and equipment would attract a written down allowance of 25% on the reducing

balance basis and tax is payable one year in arrears at the rate of 30% per annum.

BXN plc has a cost of capital of 12%.

Required:

Calculate the net present value of investing in the new plant and

equipment and advise whether the investment is financially acceptable.

(10 marks)

Discuss the causes of capital rationing in the context of investment

appraisal. (5 marks)

(15 marks)

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5. TRA Co is an American based company and is listed on a recognised stock exchange

and is financed entirely by equity. As ty 30 September 2014 the company had 150

million equity shares in issue with a market price of $7.00. In the year to30 September

2014, profit before interest and tax was $80 million.

The company in the past has exported goods to Europe and now wishes to raise £200

million to establish a subsidiary in the United Kingdom (UK). The directors want to

raise half of the amount in the form of a 10% bank loan in pound sterling and the

reminder in the form of a rights issue. The right issue will be made in America at a

price of $5.00 per share.

Other relevant information:

The UK operation is expected to generate operating profit of £25 million for the

year to 30 September 2015. Assume that the profit before interest and tax of

existing operations as at 30 September 2015 is the same as that of 30 September

2014.

The price to earnings (P/E) ratio of the company is expected to remain constant for

the year to 30 September 2015.

Tax rate in America is 25% and no tax is expected to be paid in UK for the next

three years.

The profit after interest from UK operations is remitted to America at the end of

each year and is taxable in America.

The current spot rate is $2 to £1. The expected inflation rates for the year to 30

September 2013 are: 10% in America and 8% in the UK. The one year forward

rate is 2.0176 $/£ and TRA Co can earn 3% per year on short-term deposits in the

UK and can borrow short-term in USA at 5·3% per year.

Required:

Calculate the theoretical ex-rights price per share after the rights issue.

(4 marks)

Evaluate and comment on the effect of the UK investment on:

(i) The earnings per share of TRA Co; and

(ii) The wealth of the shareholders of TRA Co. (11 marks)

(15 marks)

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Formulae Sheet

Economic Order Quantity

= 0

H

2C DC

Miller-Orr Model

Return point = Lower limit + (1/3 spread)

Spread = 3

133 transaction cost variance of cash flows

4interest rate

The Capital Asset Pricing Model

E(ri) = Rf + ßi (E (rm) – Rf)

The Asset Beta Formula

ßa = ee

e d

V(V V (1 T))

+ dd

e d

V (1 T)(V V (1 T))

The Growth Model

P0 = 0

e

D (1 g)(K g)

or P0 = 0

e

D (1 g)(r g)

Gordon’s Growth Approximation

g = bre

The weighted average cost of capital

WACC = e

e d

VV V

ke + d

e d

VV V

kd (1–T)

The Fisher formula

(1 + i) = (1 + r)(1 + h)

Purchasing Power Parity and Interest Rate Parity

S1 = S0 c

b

(1 h )(1 h )

F0 = S0 c

b

(1 i )(1 i )

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Present Value Table

Present value of 1 ie (1 + r)-n

Where r = discount rate

n = number of periods until payment

Discount rate (r)

Periods

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1

2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 2

3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 3

4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 4

5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 5

6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 6

7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 7

8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 8

9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 9

10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 10

11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 11

12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 12

13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 13

14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 14

15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1

2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 2

3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 3

4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 4

5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 5

6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 6

7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 7

8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 8

9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 9

10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 10

11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 11

12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 12

13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 13

14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 14

15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15

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Annuity Table

Present value of an annuity of 1 ie -n1 - (1 + r)

r

Where r = discount rate

n = number of periods

Discount rate (r)

Periods

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1

2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 2

3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 3

4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 4

5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 5

6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 6

7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 7

8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 8

9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 9

10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 10

11 10.37 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 11

12 11.26 10.58 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 12

13 12.13 11.35 10.63 9.986 9.394 8.853 8.358 7.904 7.487 7.103 13

14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367 14

15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1

2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 2

3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 3

4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 4

5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 5

6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 6

7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 7

8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 8

9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 9

10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 10

11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 11

12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 12

13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 13

14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 14

15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 15

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